STRATEGIC COST MANAGEMENT: JIT AND TQM

JUST IN TIME

Traditional Manufacturing
 Smooth operating activity
 steady use of workforce
 continuous machine utilization
 Spread overhead over a maximum number of products
 Inventory levels high enough to cover up inefficiencies in acquisition and/or production

Production Systems
 Push system
 Produce in anticipation of customer orders
 Store raw material, work in process, and finished goods inventory
 Pull system
 Produce as needed
 Minimal storage

Just-in-time is a philosophy centered on the reduction of costs through elimination of inventory. All
materials and components should arrive at a work station when they are needed—no earlier and no
later. Products should be completed and available to customers when the customers want them—no
earlier and no later.

Elimination of inventories eliminates storage and carrying costs; however it also eliminates the
cushion against production errors and imbalances that inventories provide. As a result, high quality
and balanced workloads are required in a JIT system to avoid costly shutdowns and customer ill will.

Because of the need for quality and balanced production, JIT has come to be closely identified with
efforts to eliminate waste in all forms, and thus is an important part of total quality management
(TQM) efforts.

The most visible aspect of JIT is the effort to reduce inventories of work in process and raw materials.
In this aspect, JIT is called stockless production, lean production, or zero inventory production (ZIP).

JIT Production – A Pull system

 Each component in a production line is produced immediately as needed by the next step in
the production line.
 This is accomplished through a kanban card. A kanban is a notification card that a
downstream machine sends to each upstream machine that feeds it with parts, authorizing
the production of just enough components to fulfill the production requirements. This is also
known as ‚pull‛ system, since these cards are initiated at the end of the production process
pulling work authorizations through the production system. WIP cannot pile up since it can
be created only with kanban authorization.

JIT Purchasing
 Supplier evaluation. The firm’s purchasing department staff evaluates and investigates every
supplier and eliminates those who could not keep up with the delivery dates.
 Supplier assistance. The firm’s engineering staff visits supplier sites and examines their
processes, not only to see if they can reliably ship high-quality parts but also to provide them
with engineering assistance to bring them up to a higher standard of product.

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  Supplier information system. The firm installs a system—which is as simple as a fax
machine or as advanced as an electronic data interchange system or linked computer
systems— that communicates with suppliers as to exactly how much of specified parts are to
be sent to the firm.
 Direct delivery: Deliveries—immediately preceding demand or use—are sent straight to the
production floor for use in manufactured products, so that no time is spent in inspecting the
parts for defects. Drivers, who bring supplies of materials, drop them off at the specific
machines that will use the materials first.

Goals of JIT
 Reduction in total cost of production/performance while increasing quality
 Elimination of any process or operation that does not add value
 Continuous improvement in production/performance efficiency

JIT Financial Benefits

 Lower investment in inventories
 Reduction in carrying & handling costs of inventories
 Reduction in risks of obsolescence
 Lower investment in factory space for inventories & production
 Reduction in total manufacturing costs

JIT Real-World View

 No wholesale implementation
 Partial: JIT & JIC
 Partial: JIT cells
 Conflict with traditional performance measures

“The shift to JIT requires a radical change in mindset and an

overhaul of the system for motivating, measuring & rewarding
performance.”

JIT & Factory Organization

JIT requires migration to cells or work cells.
 A cell is a linear or U-shaped production grouping of workers and machines.
 A cell is responsible for the entire production of a product or part, or a family of very similar
ones.
 Every member in the cell is trained to monitor and operate several (or all) machines in the
cell, or to perform all steps of a specific task.

JIT and Variances

 Vendor quality agreements minimize direct material usage variances
 Automated JIT systems minimize labor variances
 Direct labor and overhead combined into conversion costs
 Engineering changes may cause material, labor, overhead, and/or conversion variances

JIT and Accounting (Backflushing)

Backflushing is a costing system that omits recording some of the journal entries relating to the stages.
When one or some of the entries are omitted, the entries for a subsequent stage use normal or
standard costs to work backward to ‚flush out‛ the costs in the cycle for which entries were not
made. When inventories are minimal, backflushing simplifies the costing system without losing much
information as a result of simplification by not recording journal entries for work in process, purchase

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of materials, or production of finished goods.

 Three conditions for its use:

 Management wants a simple accounting system – no detailed tracking of work in process
(WIP), raw materials (RM) & WIP combined as raw and in process (RIP).
 Each product has a set of standard costs
 It yields approximately same financial results as sequential tracking – if inventories are
low or not subject to significant change between accounting periods

 Difficulties of backflushing
 Does not strictly adhere to GAAP for external reporting
 Absence of audit trails – ability of the accounting system to pinpoint uses of resources at
each step of the production process

Backflushing Variation #1: Post-manufacturing deduction

Key entries affecting RIP
 Purchase/receipts of raw materials
 Backflushing of RM component of completed work from RIP to finished goods (FG) based on
monthly physical counts
 Establishment of ending inventory accounts (RIP and FG) by adjusting conversion cost
components
 Recording of actual conversion costs as incurred throughout the period via CGS
 Backflushing of RM component of work sold from FG to cost of goods sold (COGS) based on
monthly physical counts.

Backflushing Variation #2: Use of trigger points

 Stages in sequential tracking costing system
A. Purchase of direct materials
B. Production resulting in WIP inventory
C. Completion of good finished units in inventory
D. Sale of finished goods

 Each stage is considered a trigger point.

 A trigger point is a stage in the cycle from purchase of direct materials to sale of finished goods
where journal entries are made in the accounting system.

No. of Journal- Entry Location in Cycle When

Approach Trigger Points Journal Entries Are Made

A 3 Stage A. Purchase of DM

(2 inventories: RIP & FG) Stage C. Completion of FG

Stage D. Sale of FG

B 2 Stage A. Purchase of DM

(1 inventory: I) Stage D. Sale of FG

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 C 2 Stage C. Completion of FG

(1 inventory: FG) Stage D. Sale of FG

LEAN MANUFACTURING AND ACCOUNTING FOR LEAN

Lean Manufacturing (‚lean‛ for short)—reconfiguring the manufacturing process to increase product
flow and product quality, reduce inventories, reduce waste and inefficiency, improve decision-
making, and enhance profitability. The ultimate goal is: ability to do “more” with “less”–less human
effort, fewer raw materials, less developmental time, less space, and less energy.

At the heart of lean manufacturing is the Toyota Production System (TPS). The main elements are:
1. Long-term focus on relationships with suppliers and coordination with these suppliers
2. Emphasis on balanced, continuous-flow manufacturing with stable production levels
3. Continuous improvement in product design and manufacturing processes with the objective
of eliminating waste
4. Flexible manufacturing systems in which different vehicles are produced on the same
assembly line and employees are trained for a variety of tasks.

Five Principles of Lean Manufacturing:

1. Value. Lean starts with what is of value to the customer and measures success in terms of
providing value to the customer.
2. Value stream. The value stream consists of all activities required to create customer value for
a group or family of related products or services. Lean organizations focus on the costs and
profitability of each specified value stream. As such, the cost accounting system is greatly
simplified, which gives rise to the notion of ‚lean accounting‛.
3. Pull and flow. A lean production process is scheduled to satisfy customer orders as these
orders arrive at the company (pull production). The emphasis is on reducing lead time–the
time it takes to process a customer’s order.
4. Empowerment. In the lean system, financial and non-financial measures are collected in a box
score (similar to the BSC). The lean approach produces these measures frequently (daily or
weekly) so that personnel have real-time information on their progress toward meeting goals.
5. Perfection. The lean approach emphasizes Six Sigma, continuous improvement, and
elimination of non-value-added processes.

Lean Vs Traditional Manufacturing Processes

Traditional Production Lean Manufacturing

Key focus points Reduce cost; reduce idle time Meet customer demand with short lead
time; reduce overproduction and inventory
levels

Manufacturing Goal is to meet forecasted demand Goal is to meet a customer order received
scheduling (push); production is in batches (pull); production is driven by the receipt
of customer orders

Batch production Reduce number of setups to reduce Reduce setup time to maximize
setup costs manufacturing flexibility and to reduce
inventory; maximize the ability to meet

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 diverse customer needs; the principle of
one-piece flow.

Value-Stream Income Statements:

 Definition of ‚value stream‛
 Intended to support/encourage/recognize the value of ‚lean‛
 Generate a more refined measure of ‚operating income‛

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 Cameraderie Company
Sample Value-Stream Income Statement

Digital Cameras Video Cameras Total

Sales 585,000 540,000 1,125,000
Operating costs
Materials 25,200 12,800
Labor 168,000 88,000
Equipment costs 92,400 48,400
Occupancy costs 11,200 4,800
Total operating costs 296,800 154,000 450,000
Less: Other value stream costs
Manufacturing 120,000 240,000
Selling & administrative 10,000 130,000 10,000 250,000 380,000
Value stream profit before inventory change 158,200 136,000 294,200
Less: Cost of decrease in inventory (10,000) (20,000) (30,000)
Value stream profit 148,200 116,000 264,200
Less: Non-traceable costs
Manufacturing 155,000
Selling & administrative 54,000
Total non-traceable costs 209,000
Operating income 55,200

Full Cost Accounting Vs Lean Accounting

Full Cost Accounting Lean Accounting

Key focus points Causality; linking resources, cost
drivers, and cost objects
Obtain accurate product costs
Process flow and throughput; speed up
product throughput
Facilitate the 5 principles of lean
manufacturing
Support JIT and TOC efforts; reduce
inventory and customer lead time

Strategy Full cost based; can be used to Short-term focus on reducing lead times,
implementation support long-term decisions inventory levels and value stream income;
value-stream goals can be linked to
company strategy
Focus on day-to-day decisions

Full Cost Accounting Lean Accounting

Cost allocation Trace direct costs and use cost
drivers for indirect costs
The goal is to avoid cost allocation; use of
the value stream, by aggregating products
into product families, means that many
costs can be traced directly to the value
stream so that allocation is not needed

Non-financial Can be supplemented as in a BSC Included in the box score report that
performance measures includes operational, capacity usage, and
financial measures

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 Full Cost Accounting Lean Accounting

Product cost detail Individual product; product mix Aggregation of products; product cost at
and product-mix at the detail level the value-stream level; analysis of average
analysis product cost within value stream

Full Cost Accounting Lean Accounting

Reflects the financial Only in the long term Directly shows the financial benefits of
benefits of lean lean efforts through value-stream
manufacturing? accounting and through the recognition of
the cost of decreasing inventory levels

Product costs for Products costs may or may not Assumes that a firm is a price-taker; costs
pricing play a role in pricing are not used in pricing

Reporting interval Often monthly Frequent; often weekly or daily

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TOTAL QUALITY MANAGEMENT (TQM)

Many companies have installed programs of total quality management (TQM), a broad set of
processes that focus the entire organization on providing products or services that do the best
possible job of satisfying the customer.

What it is
 Company-wide approach to quality improvements
 Seeks to eliminate poor quality and improve quality in all processes & activities
 A philosophy and modus vivendi rather than a mere objective

Three core concepts of TQM:

1. Quality Control (QC). It is concerned with the past, and deals with data obtained from
previous production, which allows action to be taken to stop the production of defective
units.
2. Quality Assurance (QA). It deals with the present, and concerns the putting in place of system
to prevent defects from occurring.
3. Quality Management (QM). It is concerned with the future, and manages people in the process
of continuous improvement to the products and services offered by the organization.

What are the Six C’s for successful implementation of TQM?

Fundamental requirements for the implementation of the TQM process are as follows:
1. Commitment. If a TQM culture is to be developed, total commitment must come from top
management. It is not sufficient to delegate ‘quality’ issues to a single person. Quality
expectations must be made clear by the top management, together with the support and
training required for its achievement.
2. Culture. Training lies at the center of effecting a change in culture and attitudes. Negative
perceptions must be changed to encourage individual contributions and to make ‘quality’ a
normal part (modus vivendi) of everyone’s job.
3. Continuous improvement. TQM should be recognized as a ‚continuous process‛, not a ‚one-
time program‛. There will always be room for improvement, however small.
4. Cooperation. TQM visualizes total employee involvement (TEI). Employee involvement and
cooperation should be sought in the development of improvement strategies and associated
performance measures.
5. Customer focus. The needs of external customers (in receipt of the final product or service)
and also the internal customers (colleagues who receive and supply goods, services or
information), should be the prime consideration.
6. Control. Documentation procedures and awareness of current best practices are essential if
TQM implementations are to function appropriately. Unless control procedures are in place,
improvements cannot be monitored and measured nor deficiencies corrected.

Strategic Importance of Quality

 ISO 9000. The current set of quality management standards developed by ISO. These provide
guidance and tools for companies that want to ensure that their products and services
consistently meet customers’ requirements and that quality is consistently improved.
 ISO 14000. A set of quality standards that address various aspects of environmental
performance, including life-cycle analysis, communication, and auditing of environmental
performance.
 Conceptual linkage between quality and profitability. A manufacturing firm with
improved quality can achieve competitive advantage and enjoy improved financial
performance, i.e., higher profitability and/or a higher return on investment.

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Accounting’s Role in the Management & Control of Quality
 Accountants can add value to the organization by providing decision-makers with relevant
financial and nonfinancial information related to quality
 Such information actively supports the quality initiatives embraced by management

Basic Terminology
 “Quality”— customer satisfaction with the total experience of a product or service,
consisting of two components:
 Design quality (focuses on the features that customers want). Design quality refers to
how closely the characteristics of a product or service meet the needs and wants of
customers. Design quality, then, involves giving customers what they desire in a
product or service.
 Performance or conformance quality (focuses on product/service performance).
Conformance quality refers to the performance of a product or service relative to its
design and product specifications. For example, if one buys an iPad and it breaks
during the first week of use, there is a failure of conformance quality, as one
anticipated it would last longer than one week.
 Total quality management (TQM)
 Importance of having a good measurement system to support TQM
 Limitations of conventional accounting systems?

Characteristics of the Comprehensive Framework for Managing/Controlling Quality

 Broad business perspective—knowledge of business processes
 Paramount role of the consumer
 Relevant financial data
 Nonfinancial performance indicators
 Feedback loops
 Linkage to operations management
 Breadth of the system—value-chain approach

Setting Quality-Related Expectations

 Six-Sigma. A business process improvement approach that seeks to find and eliminate causes
of defects and errors, reduce manufacturing cycle times and costs, improve productivity ,
better meet customer expectations, achieve higher asset utilization, and ROI in both
manufacturing and service operations.
 Six-Sigma expectation is approximately 3.4 defects per million items produced.
 Six-sigma is not likely the goal for all processes and operations. The appropriate
quality expectation is a function of strategic importance of the process and the
anticipated costs.
 Six-Sigma approach:
1. Define
2. Measure
3. Analyze
4. Improve
5. Control
 Goalpost vs. Absolute Conformance:
 Goalpost conformance assumes that the firm incurs no quality or failure cost or loss if
quality measures fall within the specified limits.

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  Absolute quality conformance (robust quality approach) requires that all products or
services meet exactly the target value with no variation allowed.

 Financial Measures & Cost of Quality (COQ)

 Relevant cost information for decision-making ():
1. Future costs and revenues that differ between decision alternatives
2. ‚Avoidable costs‛ vs. Sunk costs
3. Out-of-Pocket costs + Opportunity costs
 Cost of Quality (COQ) Reporting

COQ Reports
Four categories of quality costs include the following:
1. Prevention costs are incurred to prevent poor quality. These expenditures incurred to keep quality
defects from occurring. Examples of prevention costs include:
 quality engineering
 quality training programs
 quality planning
 quality reporting
 supplier evaluation and selection
 quality audits
 quality circles
 field trials
 design reviews

2. Appraisal costs are incurred to determine whether products and services are conforming to
requirements or customer needs. These are costs incurred in the measurement and analysis of
data to find out if products and services conform to specification/customer expectations. The
main objective is to prevent nonconforming goods from being shipped to customers. Examples of
appraisal costs include:
 inspecting and testing of materials
 packaging inspection

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  supervising appraisal activities
 process acceptance (sampling goods in process to see if the process is in control and
producing non-defective goods)
 product acceptance (sampling finished goods to determine if the finished goods meet an
acceptable quality level)
 measurement (inspection and test) equipment
 outside endorsements

3. Internal failure costs are incurred because products or services do not meet requirements and the
defect is discovered before the external sale. These costs incurred as a result of poor quality found
through appraisal prior to delivery to customers Examples of internal failure costs include:
 scrap
 rework
 downtime (due to defects)
 reinspection
 retesting
 design changes

If there are no defects, there are no internal failure costs.

4. External failure costs are incurred because products fail to meet requirements after delivery to
customers. These are incurred to rectify quality defects after unacceptable products or services
reach the customer Examples include:
 the cost of recalling defective products
 lost sales because of poor product performance
 returns and allowances because of poor quality
 warranty costs
 repair costs
 product liability
 customer dissatisfaction
 lost market share
 complaint adjustment

Conformance and Nonconformance Quality Costs

 Cost of Conformity:
 Prevention Costs
 Appraisal Costs

 Cost of Nonconformity:
 Internal Failure Costs
 External Failure Costs

Nonfinancial Quality Indicators

 Internal Nonfinancial Quality Metrics
 Process yield
 Productivity
 Machine up-time
 Safety record
 Throughput

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  Cycle time efficiency

 External Non-financial Quality Metrics

 Customer response time (CRT)
 No. of defective units shipped
 No. of customer complaints
 Delivery delays
 On-time delivery rate
 Percentage of products that experience early or excessive failure

Detecting Poor Quality:

 Control Chart – a graph that depicts successive observations of an operation (or cost) taken
at constant intervals over a specified time; related to Statistical Control Chart.
 Run Chart – a chart that shows trends in observations of a quality characteristic (or cost) over
time

Taking Corrective Action:

 Histogram – a graphical representation of the frequency of attributes or events in a given set
of data.
 Pareto Diagram (Chart) – a histogram of the frequency of factors contributing to a quality
problem, ordered from the most to the least frequent.
 ‚Cause-and-Effect” (“fishbone”) Diagram – a diagram that organizes a chain of causes and
effects to sort out the root causes of an identified quality problem.

Taguchi Quality Loss Function

 Genichi Taguchi and Y. Wu hypothesize that any variation from the exact specifications
entails a cost or loss to the firm.
 This cost or loss can be depicted by a quadratic function: the loss quadruples when the deviation
from the target doubles.
 General expression of the loss function, L(x), for an observed quality characteristic, x, is:

L(x) = k(x -T)2

Where: x = an observed value of the quality characteristic

T = the target value of the quality characteristic
k = the cost coefficient, determined by the firm’s failure costs

𝑻𝒐𝒕𝒂𝒍 𝑸𝒖𝒂𝒍𝒊𝒕𝒚 𝒄𝒐𝒔𝒕

k = (𝑻𝒐𝒍𝒆𝒓𝒂𝒏𝒄𝒆 𝑨𝒍𝒍𝒐𝒘𝒆𝒅)𝟐

Example:
Your firm has determined that no customer will accept sheet-metal deviating more than 0.05‛
from the target thickness (0.50‛). The cost to the firm is estimated as P5,000 for each rejection by a
customer.

5,000
k = (0.05 2 = 2,000,000

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 L(x) = k(x -T)2

L(0.47) = 2,000,000(0.47 – 0.50)2

L(0.47) = 1,800

Thus, if the actual thickness of a unit is 0.47, then the estimated total loss for the unit is P1,800.

ENVIRONMENTAL COST MANAGEMENT

Many organizations today are striving for greater eco-efficiency: increasing the production of goods
and services while, at the same time, decreasing production's negative effects on the environment.
Improving environmental quality may actually reduce environmental costs rather than increase them.
Environmental costs are costs incurred because poor environmental quality exists or because poor
environmental quality may exist.

The costs of dealing with environmental issues are significant and take on many forms.
 Private versus social costs
 Private environmental costs are those borne by a company or individual (e.g., the
costs incurred by an organization to clean up a polluted lake).
 Social environmental costs are costs borne by the public at large (such as the costs
incurred by taxpayers to staff the Environmental Protection Agency).

 Visible versus hidden costs

 Visible environmental costs are known and clearly identified as being tied to
environmental issues (e.g., the cost of cleaning up a polluted stream). In some cases,
these costs are only a small proportion of total hidden costs.
 Hidden environmental costs are those costs caused by environmental issues but not
yet identified as such by an entity's accounting system (e.g., the incremental cost of
installing more expensive processes to reduce pollution).

 Visible and hidden costs can be classified further, as follows:

 Monitoring costs. Costs of monitoring a production process to determine if pollution
is being generated (e.g., the cost of testing waste water for contaminants)
 Abatement costs. Costs incurred to reduce or eliminate pollution (e.g., the cost of re-
designing a product to eliminate contaminants)
 Remediation costs.Costs incurred to clean up the pollutants generated from a
production process. These costs may be either on-site or off-site.

Four categories of environmental costs are:

1. Environmental prevention cost. Costs incurred to prevent damage to the environment such
as the production of contaminants. Examples include designing processes and products to
reduce contaminants.
2. Environmental detection costs. Costs incurred to detect if the firm is in compliance with
environmental standards. Three types of environmental standards and procedures are:
 governmental regulatory laws
 voluntary standards developed by the ISO, and
 environmental policies developed by management.

An example of detection activities includes measuring contamination levels.

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 3. Environmental internal failure costs. Costs incurred after contaminants are produced but
before they are introduced into the environment. Examples of internal failure costs include
treating and disposing of toxic materials and recycling scrap.
4. Environmental external failure costs. Costs incurred after contaminants are introduced into
the environment. Realized external failure costs are external costs the firm has to pay. Unrealized
external failure costs (or societal costs) are external costs caused by the firm but paid for by society.

Environmental reporting
 An environmental cost report lists the environmental costs by category (prevention,
detection, internal failure, and external failure) and as a percentage of operating costs.
 An environmental financial report lists environmental benefits (such as income from
recycling) as well as environmental costs.

ACTIVITY-BASED MANAGEMENT (ABM)

The use of ABC as a costing tool to manage costs at activity level is known as Activity-Based
Management (ABM). Through various analyses, ABM manages activities rather than resources. It
determines what drives the activities of the organization and how these activities can be improved to
increase profitability. ABM utilizes cost information gathered through ABC.

ABM is a discipline that focuses on the management of activities as the route to improving the value
received by the customer and the profit achieved by providing this value. This discipline includes:
a. Cost driver analysis. Cost driver analysis identifies the factors that cause activities to be
performed in order to manage activity costs. An activity may be performed inefficiently due
to a particular reason. Managers have to address this cost driver to correct the root cause of
the problem.
b. Activity analysis (value analysis). This involves identification of the activities of an
organization and the activity centers (or activity cost pools that should be used in an ABC
system). Activity analysis also identifies value-added (VA) and non-value-added (NVA)
activities, so that all non-value- added activities can be eliminated from the process in order
to control costs.
c. Performance analysis. This involves the identification of appropriate measures to report the
performance of activity centers or other organizational units, consistent with each unit’s goals
and objectives. Performance analysis aims to identify the best ways to measure the
performance factors that are important to organizations in order to stimulate continuous
improvement.

Benefits of ABM
1. Cost reduction. Provision of excellent basis and focus for cost reduction.
2. Budget implementation. Provides operational management with a clear view of ‚how to
implement an activity-based budget.‛
3. Cost definition. Provision of clear understanding of the underlying causes of business
processing costs.
4. Decision making. Provision of excellent basis for effectiveness of management decision-
making.
5. Resource utilization. Identification of key process waste elements permits management
prioritization and leverage of key resource.

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Differences between ABC and ABM
ABC
ABC refers to the technique of determining the
costs of activities and the cost of output that those
activities produce.
The aim of ABC is to generate improved cost data
for use in managing a company’s activities.
End of Handouts
ABM
ABM refers to the management philosophy that
focuses on the planning, execution and
measurement of activities as the key to
competitive advantage.
Being a much broader concept, ABM strives to
use information generated by ABC for effective
business processes and profitability.
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