Chapter

7
The Conversion Cycle

Objectives for Chapter 7

Elements and procedures of a traditional production process

Data flows and procedures in a traditional cost accounting system
Accounting controls in a traditional environment
Operating features, philosophies, and technologies of a worldclass company
Just-in-time systems and the implications of maintaining excessive
inventories in the world-class environment
Importance of quality in the world-class environment
Shortcomings of traditional accounting methods in the world-class
environment
Characteristics of a world-class information system

The Continuum of Manufacturing

Practices

A World Class Company

is a company that has achieved high

standards and has undergone

fundamental changes from traditional
forms of organization and management
continuously pursues improvement in all
aspects of its operations, including its
manufacturing procedures
is highly customer oriented

Achieving World-Class Status

The world-class firm needs new accounting methods
and new information systems that:

show what matters to its customers

identify profitable products
identify profitable customers
identify opportunities for improvement in operations and
products
encourage the adoption of value-added activities and
processes within the organization and identify those that do
not add value
efficiently support multiple users with both financial and
nonfinancial information

The Conversion Cycle

The conversion cycle transforms input
resources, raw materials, labor, and
overhead into finished products or
services for sale.
The conversion cycle consists of two
subsystems:
the production system
the cost accounting system

Production System
Involves the planning, scheduling, and

control of the physical product through the

manufacturing process
determining raw materials requirements
authorizing the release of raw materials into
production
authorizing work to be conducted in the
production process
directing the movement of work through the
various stages of production

Production Methods
Continuous Processing creates a

homogeneous product through a continuous

series of standard procedures.
Batch Processing produces discrete
groups (batches) of products. Each item in
the batch is similar.
Make-to-Order Processing involves the
fabrication of discrete products in
accordance with customer specifications.

Documents in the Batch

Production System
Sales Forecast - expected demand for

the finished goods

Production Schedule - production plan
and authorization to produce
Bill of Materials (BOM) - specifies the
types and quantities of the raw materials
and subassemblies used to produce a
single finished good unit

Documents in the Batch

Production System
Route Sheet - details the production

path a particular batch will take in the

manufacturing process
sequence of operations
time allotted at each station

Work Order - uses information from the

BOM and route sheet to specify the
exact materials and production
processes for each batch

Documents in the Batch

Production System
Move Ticket - records work done in each
work center and authorizes the movement
of the batch
Materials Requisition - authorizes the
inventory warehouse to release raw
materials for use in the production process

Production Planning and Control

Sales Forecast
Inventory Status Report
Engineering Specifications
BOM and route sheets

Raw Materials Requirements

(Purchase Requisitions)

Operations Requirements

Production Scheduling
work orders
move tickets
materials requisitions
open work orders
work centers

job tickets
time cards
completed move tickets

cost accounting
payroll
prod. plan. and control

Upon Completion of the Production Process

Finished Product
and Closed Work Order

Finished Goods Warehouse

Closed Work Order

Inventory Control
status report of raw materials
and finished goods

Prod. Plan. and Control

journal voucher

General Ledger

EOQ Inventory Model

Objective: minimize total inventory costs while ensuring
that adequate inventories exist to meet current demand
Very simple too use, but assumptions are not always valid

demand is known and constant

ordering lead time is known and constant
total cost per year of placing orders decreases
as the order quantities increase
carrying costs of inventory increases as quantity
of orders increases
no quantity discounts

EOQ Inventory Model

Q=

Where

2DS
H

Q = economic order quantity

D = annual demand in units
S = fixed cost of placing each order
H = holding or carrying cost per unit per year

INVENTORY LEVEL

EOQ Inventory Model

Inventory Cycle

Daily Demand

EOQ

Reorder
Point
Lead Time

Time (days)

Cost Accounting System

Records the financial effects of the events

occurring in the production process

Initiated by the work order
Cost accounting clerk creates a new cost
record for the new batch and files in WIP
file
The records are updated as materials and
labor are used

Elements of the Cost Accounting System

Inventory Control

Work Centers

materials requisitions

job tickets
completed move tickets

COST ACCOUNTANTS
STANDARDS

Update WIP accounts

DL
DM
Mfg. OH.
Compute Variances

Cost Accounting System

Receipt of last move ticket signals

completion of the production process

clerk removes the cost sheet from WIP
file
prepares a journal voucher to transfer
balance to a finished goods inventory
account and forwards to the General
Ledger department

Summary of Internal Controls

Internal Controls
Transaction authorizations
work orders reflect a legitimate need based
upon sales forecast and the finished goods
on hand
move tickets (with authorized signature from
each work station) authorize the movement of
the batch through the various work centers
materials requisitions authorize the
warehouse to release materials to the work
centers

Internal Controls
Segregation of duties
production planning and control
department is separate from the work
centers
inventory control separate from materials
storeroom and finished goods warehouse
cost accounting function accounts for WIP
and should be separate from the work
centers in the production process

Internal Controls
Supervision
supervisors in the work centers oversee
the usage of raw materials in the
production process to ensure that all
released materials are used in production
and waste is minimized
employee time cards and job tickets are
checked for accuracy

Internal Controls
Access control
direct access to assets
storerooms, production work centers, and
finished goods warehouses
quantities in excess of standard amounts
should require approval

indirect access to assets

materials requisitions, excess materials
requisitions, and employee time cards

Internal Controls
Accounting records

pre-numbered documents
work orders
cost sheets
move tickets
job tickets
material requisitions
WIP and FGs files

Internal Controls
Independent verification
cost accounting reconciles material usage (material
requisitions) and labor usage (job tickets) with prescribed
standards, and variances are investigated
GL dept. verifies the total movement from WIP to FG by
reconciling journal vouchers from cost accounting and
inventory subsidiary ledger summaries from inventory
control
internal and external auditors periodically verify the raw
materials and FGs inventories on hand through a physical
count

Trends in Competitive Advantage

The World-Class Environment and

Manufacturing Flexibility
Customers:

want quality products

want them quickly
want variety

Achieving manufacturing flexibility incorporates

four operational characteristics:

physical reorganization of the production facilities

automation of the manufacturing process
reduction of inventories
high product quality

Physical Reorganization of the

Production Facilities
The inefficiencies inherent in the layout of traditional
plants add handling costs, conversion, time, and
excess inventories to the manufacturing process.
Employees tend to feel ownership over their
stations, which is contrary to a team concept.
The reorganization is based on flows through cells
which shorten the physical distance between the
activities, thus reducing setup and processing time,
handling costs, and inventories in the flow.

Progression of Automation in
the Manufacturing Process

Traditional

Islands of
Technology

Process
Simplification
(JIT)

Computer
Integrated
Manufacturing

Progression of Automation toward World-Class Status

Automation of the Manufacturing

Process
Traditional:
consists of many different types of machines which
require a lot of setup time
machines and operators are organized in functional
departments
WIP follows a circuitous route through the different
operations

Islands of Technology:
stand alone islands which employ computer numerical
controlled (CNC) machines that can perform multiple
operations with less human involvement
less set up time needed

Automating Manufacturing

Automating Manufacturing
Process Simplification:
reduces the complexity of the physical layout
groups of CNC machines are arranged in cells
to produce an entire part from start to finish
no human involvement in a cell

Computer Integrated Manufacturing

(CIM):

a completely automated environment which

employs automated storage and retrieval
systems (AS/RS) and robotics

Automating Manufacturing
Robotics:
use special CNC machines that are useful in
performing hazardous, difficult, and monotonous
tasks

Computer-Aided Design (CAD):

increases engineers productivity
improves accuracy
allows firms to be more responsive to market
demands
interfaces with CAM and MRPII systems

Automating Manufacturing
Computer Aided Manufacturing (CAM):
uses computers to control the physical
manufacturing process
provides greater precision, speed, and control than
human production processes

Manufacturing Resources Planning (MRP II):

an extension of materials requirements planning
(MRP)
more than inventory management--it is a system for
coordinating the activities of the entire firm

Automating Manufacturing
Enterprise Resource Planning (ERP)
Systems:
huge commercial software packages that support the
information needs of the entire organization, not just
the manufacturing functions
automates all business functions along with full
financial and managerial reporting capability

Electronic Data Interchange (EDI):

external communications with its customers and
suppliers via Internet or direct connection

Accounting and MRP

The Evils of Inventories

Inventories cost money and

represent an investment
need to be insured and stored
can become obsolete over time

Inventories camouflage production

problems.
Willingness to maintain inventories can
precipitate overproduction.

How can inventories be

reduced?
Just-in time (JIT) manufacturing is a

model that fosters inventories

reduction and even elimination. It is
based on the following assumptions:

zero defects
zero setup time
small lot sizes
zero inventories
zero lead times and reliable vendors
team attitude

Product Quality
is important because poor quality is

expensive to the firm via scrap,

reworking, scheduling delays, extra
inventories to compensate for defective
parts, warranty claims, and service
is a basis on which world-class
manufacturers compete
can be improved though control point
methods such as statistical process
control

Whats Wrong with Traditional Cost

Accounting Information?
Inaccurate cost allocations
Time lag in reporting
Financial orientation
Emphasis on standard costs

Activity Based Costing (ABC)

is an information system that provides

managers with information about activities

and cost objects
assumes that activities cause costs and
products (and other cost objects) create a
demand for activities
is different from traditional accounting system
since ABC has multiple activity drivers,
whereas traditional accounting has only one,
e.g. machine hours

Allocation of Costs Using ABC

Activity Management
Managers must understand which
activities should be performed and how
best to perform them.
Managers should deploy resources to
activities that yield maximum benefits.
Managers should seek to improve those
factories most important to their customers.

Activity Management Tasks

Evaluating manufacturing activities
Identifying nonessential activities
Identifying cost drivers
Comparing activities to
benchmarks
Establishing links
between key activities

The World-Class Information

System
is the integration of all the systems functional and technological
components:
basic accounting applications
ABC
materials requirements planning
capacity planning
inventory control
bill-of-materials
master productions schedule
forecasting
order entry
computer-aided design
computer-aided manufacturing
EDI communications links

Need for New Performance

Measures in the Information Pyramid

Control Issues in the WCIS

Paperless environment - no traditional audit trail
Automatic transactions - need assurance that:
the system places orders only when inventory is
needed
inventory orders are placed only with approved
vendors
the quantity of items ordered is correct for the needs
of the organization
programmed procedures matching electronic
controls data before initiating payment perform
correctly
Networking considerations