CA Sri Lanka CL3 Advanced Management Accounting Study Text PDF

STUDY TEXT CA SRI LANKA CURRICULUM 2020  First edition 2020 ISBN 9781 5097 3123 7 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine...

STUDY TEXT CA SRI LANKA CURRICULUM 2020  First edition 2020 ISBN 9781 5097 3123 7 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place 142-144 Uxbridge Road London W12 8AA www.bpp.com/learningmedia The copyright in this publication is owned by BPP Learning Media Ltd. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the copyright holder. The contents of this book are intended as a guide and not professional advice and every effort has been made to ensure that the contents of this book are correct at the time of going to press by CA Sri Lanka, BPP Learning Media, the Editor and the Author. Every effort has been made to contact the copyright holders of any material reproduced within this publication. If any have been inadvertently overlooked, CA Sri Lanka and BPP Learning Media will be pleased to make the appropriate credits in any subsequent reprints or editions. We are grateful to CA Sri Lanka for permission to reproduce the Learning Outcomes and past examination questions, the copyright of which is owned by CA Sri Lanka, and to the Association of Chartered Certified Accountants and Chartered Institute of Management Accountants for use of past examination questions in which they hold the copyright. © BPP Learning Media Ltd 2020 ii Contents Page Introduction iv Chapter features vi Learning outcomes vii Action verbs checklist xviii CL3 – Advanced Management Accounting 20% Part A Cost Management 1 Modern Manufacturing Environment 3 2 Activity Based Costing 55 3 Strategic Cost Management & Value Creation 87 4 Environmental Aspects of Cost Management 117 5 Learning Curve 131 Part B Planning & Controlling 25% 6 Standard Costing & Variance Analysis 151 7 Capacity Planning 213 8 Budgeting 223 9 Responsibility Centres & Transfer Pricing 267 Index Introduction iii  Introduction CL3 Advanced Management Accounting The Corporate Level course module for Advanced Management Accounting builds on the same combination discussed under Business Level Management Accounting by having relevant business mathematical angles covered in conjunction with the relevant management accounting topics, with emphasis on interpretation of results, as well as topics such as Responsibility Centre Accounting, Transfer Pricing and Working Capital Management. You are also expected to be able understand risk and uncertainty and use decision making techniques relevant to both short and long term Syllabus structure Main syllabus areas Weightings A. Cost Management 20% B. Planning & Controlling 25% C. Decision Making 30% D. Risk & Uncertainty 15% E. Working Capital Management 10% One of the key elements in examination success is practice. It is important that not only you fully understand the topics by reading carefully the information contained in this study text, but it is also vital that you practise the techniques and apply the principles that you have learned. In order to do this, you should:  Work through all the examples provided within the chapters and review the solutions, ensuring that you understand them;  Complete the progress test for each chapter. In addition, you should use the Revision Kit. These questions will provide you with excellent examination practice when you are in the revision phase of your studies. iv CL3 Advanced Management Accounting Pillar structure The Chartered Accountant of Sri Lanka Curriculum 2020 is structured around four progressively ascending levels of competency, namely, Business I, Business II, Corporate and Strategic Levels The Corporate Level builds technical abilities whilst enhancing interpersonal and communication skills and problem resolution skills as required of a Certified Senior Business Accountant. The Curriculum is also subdivided into specific subject areas or knowledge pillars and learning material is delivered to meet the knowledge requirements. These Knowledge Pillars focus on imparting the technical knowledge required of a competent CA and comprise of five pillars that focus on the following subject areas: Knowledge Pillar 1: Audit, Assurance and Ethics (AA&E) Knowledge Pillar 2: Financial Accounting and Reporting (FA&R) Knowledge Pillar 3: Performance Measurement and Risk (PM&R) Knowledge Pillar 4: Taxation and Law (T&L) Knowledge Pillar 5: Business Management and Strategy (BM&S) Introduction v  Chapter features Each chapter contains a number of helpful features to guide you through each topic. Topic list This tells you what you will be studying in the chapter. The topic items form the numbered headings within the chapter. Chapter The introduction puts the chapter topic into perspective and explains why it is introduction important, both within your studies and within your practical working life. Learning The learning outcomes issued for the module by CA Sri Lanka are listed at the Outcomes beginning of the chapter, with reference to the chapter section within which coverage will be found. Key terms These are definitions of important concepts that you really need to know and understand before the exam. Examples These are illustrations of particular techniques or concepts with a worked solution or explanation provided immediately afterwards. Case study Often based on real world scenarios and contemporary issues, these examples or illustrations are designed to enrich your understanding of a topic and add practical emphasis. Questions These are questions that enable you to practise a technique or test your understanding. You will find the answer underneath the question. Formula to learn These are the formula that you are required to learn for the exam. Section This summarises the key points to remember from each section. introduction Chapter roundup This provides a recap of the key areas covered in the chapter. Progress Test Progress tests at the end of each chapter are designed to test your memory. Bold text Throughout the study text you will see that some of the text is in bold type. This is to add emphasis and to help you to grasp the key elements within a sentence or paragraph. vi CL3 Advanced Management Accounting Learning outcomes CA Sri Lanka's Learning outcomes for the Module are set out on the following pages. They are cross-referenced to the chapter in the Study Text where they are covered. Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component A. Cost Management: 1.1 Modern 1.1.1 Identify the drivers of change in Changes in the modern 1 20% manufacturing the modern manufacturing manufacturing environment. environment environment. 1.1.2 Discuss the concept of just-in- Just-in-time vs Just in case. 1 time and the impact of just-in-time in Philosophy of Just-in-time. a modern organisation. Advantage and disadvantages of just-in-time. 1.1.3 Discuss the importance of Principles of total quality 1 quality costing as a part of total management and the supporting quality management. concepts such as lean manufacturing, six sigma, kaizen. 1.1.4 Apply throughput accounting Theory of constraints & 1 principles for profit reporting and throughput accounting. inventory valuation. Classification of quality costs into prevention costs, appraisal costs, internal failure costs and external failure costs. Compute the ‘optimum product mix’ when there are bottleneck resources. 1.1.5 Discuss the pros and cons of Backflush costing. 1 backflush costing. Introduction vii  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 1.1.6 Discuss the evolution of Evolution of Systems (MRP I, MRP 1 resource planning and management II, ERP I, ERP II). systems. 1.2 Activity based 1.2.1 Discuss the emergence of Emergence of ABC in modern 2 costing activity based costing (ABC) system. environment. 1.2.2 Discuss the pros and cons of Product and service costing using 2 ABC system with traditional ABC. marginal and absorption costing Advantages and disadvantages of systems. ABC system compared against traditional costing systems. 1.2.3 Review stages in designing ABC Designing process and practical 2 system & activity hierarchy. limitations for implementations. 1.2.4 Apply time-driven ABC method. Time-driven ABC method as a 2 solution for limitations in traditional ABC system. 1.2.5 Discuss the use of ABC system Costs of resources supplied, costs 2 as resource consumption model. of resources used and cost of unused capacity. 1.2.6 Evaluate the importance of Activity based management. 2 activity based management. 1.3 Strategic cost 1.3.1 Discuss the value creation Value chain analysis, 3 management & value processes in organisation to enhance Basics of supply chain creation long term profits. management. Target costing approach and limitations. Life cycle costing and its implications for marketing strategies. Business process re- engineering and elimination on non-value adding activities and reduction of activity costs. ion viii CL3 Advanced Management Accounting  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 1.3.2 Analyse direct customer Customer & channel profitability 3 profitability and distribution channel analysis. profitability. 1.3.3 Apply learning curves to Learning curve & its use in 5, 6 estimate time and cost for activities, predicting product/service costs, products and services. including derivation of the learning rate and learning index. 1.4 Environmental 1.4.1 Differentiate conventional Definitions of environmental 4 aspects of cost management accounting from costs (using quality costing management environmental management framework) and benefits. accounting (EMA). Implications of EMA to product pricing, budgeting, decision making etc. Difficulties in measuring environmental costs and their impact on external environment. 1.4.2 Discuss different frameworks Popular contemporary 4 developed for EMA. frameworks developed by researchers. 1.4.3 Apply different Tools/methods for identification 4 techniques/tools used to identify such as input/output analysis, environmental impact of an process flow charts, organisation. environmental activity based costing. Introduction ix  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component B. Planning & 2.1 Standard costing 2.1.1 Compute basic variances under Basic variances under absorption 6 Controlling: 25% & variance analysis absorption costing & marginal costing & marginal costing: costing systems. Material/labour/variable overhead (rate & efficiency). Fixed overhead – expenditure & volume (split of capacity & efficiency). Sales: Price & sales volume (contribution/profit). 2.1.2 Prepare variance accounts. Accounting for variances in the 6 integrated accounting system. 2.1.3 Interpret performance Interpretation of variances. 6 differences and inter-relationships Interrelationship between between variances. variances. 2.1.4 Analyse the Split material usage and labour 6 usage/efficiency/volume variances efficiency variances into mix & by subdividing the total into mix & yield variances. yield/quantity variances. Split sales volume (contribution/ profit) variance into sales mix & sales quantity variances, planning and operational variances 2.1.5 Analyse the variances in Planning and operational 6 planning and operational variances variances and its purpose. when standards are revised. 2.1.6 Prepare a statement that The use of variances to reconcile 6 reconciles budgeted profit with the the budgeted and actual profits actual profit calculated using that have been calculated using absorption costing/marginal costing. absorption/marginal costing. 2.1.7 Discuss the importance of Variance investigation – factors & 6 investigating variances. tools, percentage variance. ion x CL3 Advanced Management Accounting  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 2.1.8 Evaluate the applicability of Advantages of standard costing, 6 standard costing in modern business disadvantages of standard environment. costing/criticisms in modern environment. Standardisation in a service environment. Applicability of benchmarking vs standard costing. 2.2 Capacity planning 2.2.1 Evaluate different measures of Measuring design capacity, 7 capacity and utilisation. effective capacity, utilisation & efficiency. 2.2.2 Discuss demand management When demand exceeds capacity, 7 strategies. when capacity exceeds demand, seasonal demand. 2.2.3 Apply short-term capacity Changing inventory levels, 7 modifying strategies. varying workforce, overtime or idle time, subcontracting. 2.2.4 Apply long-term capacity Leading demand (incremental 7 planning options and evaluation expansion, one-step expansion), tools. capacity lags with demand (incremental expansion), average capacity with incremental expansion, evaluation tools including NPV, ROI & decisions trees (illustrations only). Introduction xi  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 2.3 Budgeting 2.3.1 Explain the purposes of Purposes of budgeting (planning, 8 budgeting and their conflicts. controlling, coordination & communication, motivation, authorisation and performance evaluation) & their conflicts. 2.3.2 Discuss the alternative Alternative approaches to 8 approaches to budgeting. budgeting: Top down vs bottom up (participative budgeting) Incremental vs zero based Periodic vs rolling Activity based budgeting 2.3.3 Discuss the relevance of non- Balance scorecard. 8 financial indicators in performance measurement. 2.3.4 Outline behavioural issues in Behavioral issues in budgeting. 8 budgeting. 2.3.5 Differentiate traditional Beyond budgeting and its 8 budgeting from beyond budgeting. application to private and public entities. Arguments for and against beyond budgeting. 2.3.6 Discuss how business analytics Statistical modelling and big data 8 supplement traditional budgeting mining for forecasting and and planning with forecasts and budgeting. predictions. ion xii CL3 Advanced Management Accounting  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 2.4 Performance 2.4.1 Evaluate the performance of Responsibility centres; Revenue, 9 measurement: the divisions of a decentralised cost, profit and investment Responsibility centres organisation. centers & performance metrics (profitability, liquidity & asset management ratios, return on investment, residual income, economic value added etc). 2.4.2 Discuss the behavioural Behavioural consequences of 9 implications of divisional responsibility centre performance performance measures. management. 2.5 Perfomance The theory of transfer pricing, 9 2.5.1 Discuss transfer pricing measurement: including perfect, imperfect and methods. Transfer pricing no market for intermediate good. Transfer pricing methods; Maximum and minimum price, cost based transfer pricing, market based transfer pricing, negotiated pricing, dual pricing and lump sum payments as means of addressing some issues. 2.5.2 Evaluate the behavioural Effects of transfer pricing 9 effects of transfer pricing. (motivation, autonomy of individual divisions, sub optimal decisions; divisional and group profitability). C. Decision Making: 3.1 Optimising with 3.1.1 Apply graphical method for Profit maximisation or cost 10 30% multiple limiting optimising with multiple limiting minimisation problems with factors factors. graphical approach, constraints & shadow price. Introduction xiii  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 3.1.2 Formulate the initial linear Linear programming with simplex 10 programming model using simplex method (only initial model method and interpret the final linear development and interpreting the programming model. final solution). 3.1.3 Apply BEP for multiple Multi product break-even analysis 10 products. computations & charts. 3.2 Relevant costing 3.2.1 Apply relevant cost concept for Make or buy decisions 10 for short-term short-term decision making. Shut down decisions decisions Special pricing decisions Further processing decisions 3.3 Long-term 3.3.1 Evaluate projects with tax Incorporating tax into the 11 decision making; implications. discount rate and cash flows. advanced investment appraisal 3.3.2 Apply monetary method and Inflation; monetary method and 11 real method to incorporate the real method. impact of inflation in project appraisals. 3.3.3 Evaluate projects with unequal Unequal life (annual equivalent 11 life cycles such as assets method, least common multiple replacements. method). Assets replacement decisions. ion xiv CL3 Advanced Management Accounting  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 3.3.4 Evaluate projects with a capital Prioritisation of projects subject 11 rationing situation. to single period capital rationing using: Profitability index for divisible projects. Combined NPV method for indivisible projects. 3.3.5 Discuss the strengths & Strengths and weaknesses of 11 weaknesses of investment appraisal accounting rate of return, payback, techniques. net present value, internal rate of return. Modified IRR as a solution for drawbacks of IRR (concept of terminal value). 3.3.6 Assess non-financial factors for Environmental, social and 11 projects evaluation. political aspects of projects. 3.3.7 Review project’s results Post completion audit. 11 through post completion audit. Project abandonment decisions. Economic Net Present Value 11 3.3.8 Discuss public/social project (ENPV), Economic Internal Rate evaluation techniques (concepts of Return (EIRR), Shadow Pricing only. No calculations expected). of Economic Costs and Benefits, Social Costs & Benefits. 3.4 Pricing decisions 3.4.1 Apply marginal approach to Optimum selling price & quantity 12 arrive at optimum selling price & for firms in perfect competition, quantity. oligopoly, monopoly & monopolistic competition. 3.4.2 Apply price elasticity of Application of price elasticity of 12 demand for pricing. demand for perfect/imperfect competition. Introduction xv  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component 3.4.3 Discuss different market based Market penetration, market 12 pricing strategies and their skimming, premium pricing, consequences. loss leader, bundling, product differentiation, price discrimination. 3.5 Big data for 3.5.1 Discuss the implications of big Business analytics for data driven 13 decision making data for operational & strategic decisions at operational and decision making. strategic decision making. 3.5.2 Evaluate the benefits & costs of Benefits & costs of big data. 13 big data for an organisation. D. Risk & Uncertainty: 4.1 Decision tree 4.1.1 Apply probability in decision Decision tree. 14 15% trees for multi stage decision Value of perfect and imperfect problems. information. 4.2 Investment 4.2.1 Evaluate projects under risk Risk adjustment; certainty 14 appraisal with risk considerations. equivalent, risk adjusted discount rate. 4.2.2 Review results of appraisal Sensitivity analysis in project 14 with sensitivity analysis. appraisals. 4.2.3 Draw conclusions with Monte Monte Carlo simulation. 14 Carlo simulation. 4.2.4 Discuss downside risks in Downside risks (Value at Risk) in 14 projects. projects. 4.3 Risk management 4.3.1 Review the risk management Overview of risk management 14 process of an organisation. process. 4.3.2 Apply TARA framework for a TARA framework (Transfer, 14 given scenario. Avoidance, Reduction & Acceptance of Risks). ion xvi CL3 Advanced Management Accounting  Knowledge Syllabus Area Learning Outcomes Specific Knowledge Chapter Component E. Working Capital 5.1 Managing working 5.1.1 Illustrate the concepts relating Gross working capital, net 15 Management : 10% capital to working capital management. working capital, working capital management, working capital policy. 5.1.2 Discuss working capital Working capital investment & 15 investment and financing policies. financing policies: Conservative, moderate & aggressive. 5.1.3 Analyse the impact of working Working capital cycle with key 15 capital cycle to a firm operating in ratios, strategies for trading/manufacturing/service improvement, overtrading. sectors. 5.2 Receivables 5.2.1 Recommend the strategies for Receivable & payable 15 & payables managing receivables & payables. management strategies: management Credit control: credit policy, collection process, age analysis. Settlement discounts. Factoring of receivables. Payment methods. 5.3 Inventory 5.3.1 Evaluate the impact to the EOQ calculation with quantity 15 management economic order quantity when discounts. discounts are available. 5.3.2 Discuss the use of ABC ABC classification for inventory 15 classification, JIT arrangements for management, cost of stocks & JIT inventory management. arrangements. 5.4 Cash/treasury 5.4.1 Discuss the importance of cash Motives to hold cash, concept of 15 management management. float, cash flow synchronisation. 5.4.2 Evaluate short-term sources of Sources of short-term financing, 15 finances. import/export financing. 5.4.3 Evaluate short-term investment Short-term investments: 15 strategies. Active & passive investment strategies. Criteria (maturity, risk, return, liquidity, diversity). Types of instruments. Treasury bill & bond pricing. Introduction xvii  Action verbs checklist Knowledge Process Verb List Verb Definitions Tier - 1 Remember Define Describe exactly the nature, scope or meaning Recall important information Draw Produce (a picture or diagram) Identify Recognise, establish or select after consideration List Write the connected items one below the other Relate To establish logical or causal connections State Express something definitely or clearly Tier - 2 Calculate/Compute Make a mathematical computation Comprehension Explain important Discuss Examine in detail by argument showing information different aspects, for the purpose of arriving at a conclusion Explain Make a clear description in detail revealing relevant facts Interpret Present in understandable terms or to translate Recognise To show validity or otherwise, using knowledge or contextual experience Record Enter relevant entries in detail Summarise Give a brief statement of the main points (in facts or figures) Classify Allocate into categories Describe Communicate the key features Provide Give illustrations to support or illuminate a point or assertion Tier - 3 Application Apply Put to practical use Use knowledge in a Assess Determine the value, nature, ability setting other than the or quality one in which it was learned/solve close- Demonstrate Prove, especially with examples ended problems Graph Represent by means of a graph Prepare Make ready for a particular purpose Prioritise Arrange or do in order of importance Reconcile Make consistent with another Solve To find a solution through calculations and/ or explanations xviii CL3 Advanced Management Accounting ion Knowledge Process Verb List Verb Definitions Conduct Organize and carry out a task Communicate Transmit thoughts or knowledge Display Make evident or noticeable Perform Do or execute, usually in the sense of a complex procedure Reconcile Make or prove consistent or compatible or show differences Set Fix or establish Select Choose from a range of options or possibilities Support Assist to make decisions by providing appropriate information about respective concepts Use Apply in a practical way Undertake Commit to do or perform Tier - 4 Analysis Analyse Examine in detail in order to determine the solution or outcome Draw relations among Compare Examine for the purpose of ideas and to compare discovering similarities and Contrast Examine in order to show contrast/solve open- unlikeness or differences ended problems Construct Build or make a diagram, model or formula Differentiate Constitute a difference that distinguishes something Outline Make a summary of significant features Write Provide word descriptions to express an opinion or idea Tier - 5 Evaluate Advise Offer suggestions about the best course of Formation of action in a manner suited to the recipient judgments and Convince To persuade others to believe something decisions about the using evidence and/or argument value of methods, ideas, Criticise Form and express a judgment people or products Comment Provide written remarks expressing an opinion in both positive and negative perspectives Evaluate To determine the significance by careful appraisal Conclude Form a judgment about, or determine or resolve the outcome of, an issue through a process involving reasoning Determine Ascertain or conclude after analysis and consideration; judge Introduction xix Knowledge Process Verb List Verb Definitions Justify Give valid reasons or evidence for Review Study critically with a view to correction or improvement Recommend A suggestion or proposal as to the best course of action Resolve Settle or find a solution to a problem or contentious matter Validate Check or prove the accuracy Tier - 6 Synthesis Compile Produce by assembling information Solve unfamiliar problems by collected from various sources combining different aspects Design Devise the form or structure according to to form a unique or novel a plan solution Develop To disclose, discover, perfect or unfold a plan or idea Propose To form or declare a plan or intention for consideration or adoption Anticipate Foresee, or experience or realise beforehand Draft Write original material for the scrutiny of others Formulate Devise and put into words Plan Devise the plan for an assurance engagement Report Give the formal final conclusion for an assurance engagement Submit Send a completed document to a particular party Suggest Put forward an idea or give reasons Synthesize Make or propose a new concepts or ideas by combining existing knowledge in different aspects xx CL3 Advanced Management Accounting CL3 | Part A: Cost Management 2 CA Sri Lanka  CHAPTER INTRODUCTION This chapter will review the modern manufacturing environment. We will review the problems with traditional management accounting and then look at how this has impacted on the modern approaches. Knowledge Component A Cost management 1.1 Modern manufacturing 1.1.1 Identify the drivers of change in the modern manufacturing environment environment. 1.1.2 Discuss the concept of Just-in-time and the impact of just-in-time in a modern organisation. 1.1.3 Discuss the importance of quality costing as a part of total quality management. 1.1.4 Apply throughput accounting principles for profit reporting and inventory valuation. 1.1.5 Discuss the pros and cons of Backflush costing. 1.1.6 Discuss the evolution of resource planning and management systems. 3 CL3 | Chapter 1: Modern Manufacturing Environment LEARNING CHAPTER CONTENTS OUTCOME 1 Problems with traditional management accounting 1.1.1 2 Just-in-time systems 1.1.2 3 Total quality management 1.1.3 4 Lean manufacturing, six sigma, kaizen 1.1.3 5 Throughput accounting 1.1.4 6 Performance measures in throughput accounting 1.1.4 7 Throughput and decision making 1.1.4 8 Backflush accounting 1.1.5 9 Evolution of systems – MRP & ERP 1.1.6 1 Problems with traditional management accounting Traditional management accounting systems are allegedly inadequate for a modern business environment that focuses on marketing, customer service, employee involvement and total quality, and for modern industry using advanced manufacturing technology. 1.1 The limitations of traditional management accounting A UK report by Scapen, The Future Direction of UK Management Accounting Practice, highlighted a number of recent changes in the management accounting environment. These included:  Globalisation and increased competition  Information technology changes resulting in changes in production and information flows  Changes in organisations including internal reorganisations and external mergers Traditional management accounting systems may be inadequate for a modern business environment that focuses on marketing, customer service, employee involvement and total quality, and for modern industry using advanced manufacturing technology. 4 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment 1.2 Cost reporting Costs are generally reported in a way that reflects organisational structure, notably on a functional basis ('production costs', 'administration overheads'). The things that businesses do, however, are 'processes' that cut across functional boundaries. Traditional management accounting systems do not recognise this. 1.3 Absorption costing The traditional methods of costing products have been largely based on absorption costing with direct labour hour recovery rates. These methods are often inappropriate in the modern environment. Activity based costing (ABC) provides a better method of allocating costs, based on cause and effect relationships, but may be expensive to implement. 1.4 Standard costing Doubts about the suitability in the modern business environment of both the general philosophy and the detailed operation of standard costing have arisen. 1.5 Short-term financial measures Much of the output of traditional management accounting consists of short-term financial performance measures such as costs, variances and so on. Many of these are produced too long after the event and are too narrowly focused. A much wider view is now necessary, together with the realisation that expenditure cannot continue to be evaluated on purely financial grounds. The non- financial benefits can be extremely important (for example, better product quality) and not all of the financial benefits are easily quantified (for example, shorter set-up times, improved capacity utilisation). 1.6 Cost accounting methods Traditional cost accounting traces raw materials to various production stages via work in progress (WIP), to the next stage and finally to finished goods, resulting in thousands of transaction entries. With just-in-time (JIT) systems, production flows through the factory on a continual basis with near-zero inventories and very low batch sizes and so such transaction entries become needlessly complicated and uninformative. Cost accounting and recording systems can therefore be greatly simplified in the modern environment. CA Sri Lanka 5 CL3 | Chapter 1: Modern Manufacturing Environment 1.7 Performance measures Traditional management accounting performance measures can produce the wrong type of response. Measurement Response Consequence of action Purchase price Buy in greater bulk to Excess inventory variance reduce unit price Higher holding costs Quality and reliability of delivery times ignored Labour efficiency Encourage greater output Possibly excess variance inventory of the wrong products Machine utilisation Encourage more running Possibly excess time inventory of the wrong products Cost of scrap Rework items to reduce Production flow held scrap up by reworking Scrap factor included Supervisor aims to achieve No motivation to get in standard costs actual scrap = standard it right first time scrap Traditional Produce more output to Excess inventory, absorption costing reduce unit costs and/or possibly of unwanted over-recover overhead products Cost centre reporting Management focus is on Lack of attention to cost centre activities, not activities where cost overheads reduction possibilities might exist 1.8 Timing As we will learn later in this chapter, the cost of a product is substantially determined when it is being designed, not when it is in production. The materials that will be used, the machines and labour required, are largely determined at the design stage. In the car industry, 85% of all future product costs are determined by the end of the testing stage. Management accountants, however, continue to direct their efforts to the production stage. 6 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment 1.9 Controllability Only a small proportion of 'direct costs' are genuinely controllable in the short term. Controllable direct costs are about 10% of total costs, whereas controllable overhead costs represent about 27%. The reason why, in spite of this, accountants do not devote nearly three times as much effort to analysing overhead costs as they devote to direct costs may be because overheads are more difficult to measure. 1.10 Different assets Traditional measures cannot always deal with assets other than tangible assets, such as knowledge-based assets. Systems need to be able to decide which resources drive value, determine how knowledge-based assets help the organisation determine its strategic value and develop performance indicators that will help determine resource allocation and further strategic development. This should link with risk management of those assets, designed to minimise the risk of knowledge loss by, for example, spreading knowledge more widely over the organisation. 1.10.1 Customers Many costs are driven by customers (delivery costs, discounts, after-sales service and so on), but conventional cost accounting does not recognise this. Companies may be trading with certain customers at a loss but not realise it because costs are not analysed in a way that would reveal it. 1.11 The solution Whether all, or any, of the above criticisms are well founded is, of course, debatable. What is indisputable, however, is that changes are taking place in management accounting in order to meet the challenge of modern developments. These changes are fuelled by changes in information technology highlighted above. More information can now be stored and made easily available to non- financial managers. Information will be presented to assist strategic and business decisions, and to show more clearly to operational managers how their centre's performance links with the broader priorities of the business. Management accountants are also becoming more proactively involved in a wider range of business decisions such as assessing the consequences of mergers or advising on the financial implications of risk management policies. CA Sri Lanka 7 CL3 | Chapter 1: Modern Manufacturing Environment 2 Just-in-time systems A just-in-time (JIT) environment is operated, with buffer inventory kept only when there is a bottleneck resource. A business is an organisation that is oriented towards making a profit. 2.1 Overview of JIT In traditional manufacturing, where there is a production process with several stages, management seek to insulate each stage in the process from disruption by another stage, by means of producing for, and holding, inventory. With JIT, a disruption at any point in the system becomes a problem for the whole operation to resolve. Supporters of JIT management argue that this will improve the likelihood of the problem being resolved, because it is in the interests of everyone to resolve it. They also argue that inventories help to hide problems within the system, so that problems go unnoticed for too long. Just-in-time (JIT) is a system whose objective is to produce or to procure products or components as they are required (by a customer or for use) rather than for inventory. A JIT system is a 'pull' system, which responds to demand, in contrast to a 'push' system, in which inventories act as buffers between the different elements of the system, such as purchasing, production and sales. Just-in-time production is a production system that is driven by demand for finished products whereby each component on a production line is produced only when needed for the next stage. Just-in-time purchasing is a purchasing system in which material purchases are contracted so that the receipt and usage of material, to the maximum extent possible, coincide. (CIMA Official Terminology) 2.2 Operational requirements of JIT High Disruption in production due to errors in quality will reduce quality throughput and, also, the dependability of internal supply Speed Throughput in the operation must be fast so that customer orders can be met by production rather than from inventory Reliability Production must be reliable and not subject to hold-ups Flexibility Production must be flexible, and in small batch sizes, to respond immediately to customer orders Lower cost High-quality production, faster throughput and elimination of errors will result in reduced costs 8 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment A consequence of JIT is that if there is no immediate demand for output, the operation should not produce goods for inventory. Average capacity utilisation could therefore be low (lower than in a traditional manufacturing operation). With a traditional manufacturing system, however, a higher capacity utilisation would only be achieved by producing for inventory at different stages of the production process. Supporters of JIT argue that there is no value in producing for inventory and, as suggested above, it could damage the overall efficiency of an operation. So whereas traditional manufacturing systems are 'push' systems (a delivery from a supplier pushes products through production), JIT systems are 'pull' systems (demand from a customer pulls products through production). 'Push' systems 'Pull' systems Supplier production customer Supplier  production  customer 2.3 The JIT philosophy JIT can be regarded as an approach to management that encompasses a commitment to continuous improvement and the search for excellence in the design and operation of the production management system. Its aim is to streamline the flow of products through the production process and into the hands of customers. The JIT philosophy originated in Japan in the 1970s, with companies such as the car manufacturer Toyota. At its most basic, the philosophy is: (a) To do things well, and gradually do them better (continuous improvement) (b) To squeeze waste out of the system A criticism of JIT, in its extreme form, is that having no inventory between any stages in the production process ignores the fact that some stages, by their very nature, could be less reliable than others, and more prone to disruption. It could therefore be argued that some inventory should be held at these stages to provide a degree of extra protection to the rest of the operation. CA Sri Lanka 9 CL3 | Chapter 1: Modern Manufacturing Environment 2.3.1 Three key elements in the JIT philosophy Elimination of Waste is defined as any activity that does not add value. waste Examples of waste identified by Toyota were:  Waiting time. Waiting time can be measured by labour efficiency and machine efficiency.  Transport. Moving items around a plant does not add value. Waste can be reduced by changing the layout of the factory floor so as to minimise the movement of materials.  Inventory. The target should be to eliminate all inventory by tackling the things that cause it to build up. The JIT is a cultural issue, and its philosophy has to be embraced involvement of by everyone involved in the operation if it is to be applied all staff in the successfully. Critics of JIT argue that management efforts to operation involve all staff can be patronising. Continuous The ideal target is to meet demand immediately with perfect improvement quality and no waste. In practice, this ideal is never achieved. However, the JIT philosophy is that an organisation should work towards the ideal. 2.4 JIT techniques 2.4.1 Management techniques JIT is not just a philosophy, it is also a collection of management techniques. Some of these techniques relate to basic working practices. (a) Work standards. Work standards should be established and followed by everyone at all times. (b) Flexibility in responsibilities. The organisation should provide for the possibility of expanding the responsibilities of any individual to the extent of their capabilities, regardless of the individual's position in the organisation. Grading structures and restrictive working practices should be abolished. (c) Equality of all people working in the organisation. Equality should exist and be visible. For example, there should be a single staff canteen for everyone, without a special executive dining area; and all staff, including managers, might be required to wear the same uniform. An example of where such practices occur is the car manufacturer Honda. 10 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment (d) Autonomy. Authority should be delegated to the individuals directly responsible for the activities of the operation. Management should support people on the shop floor, not direct them. For example, if a quality problem arises, an operative on the production line should have the authority to bring the line to a halt. Gathering data about performance should be delegated to the shop floor and the individuals who use it. Shop floor staff should also be given the first opportunity to solve problems affecting their work, and expert help should only be sought if it is needed. (e) Development of personnel. Individual workers should be developed and trained. (f) Quality of working life. The quality of working life should be improved, through better work area facilities, job security, involvement of everyone in job-related decision making, and so on. (g) Creativity. Employees should be encouraged to be creative in devising improvements to the way their work is done. 2.4.2 Other JIT techniques and methodologies (a) Design for manufacture. In many industries, the way that a product is designed determines a large proportion of its eventual production costs. Production costs can therefore be significantly reduced at the design stage, for example by reducing the number of different components and sub- assemblies required in the product. (b) Use several small, simple machines, rather than a single large and more complex machine. Small machines can be moved around more easily, and so offer greater flexibility in shop floor layout. The risk of making a bad and costly investment decision is reduced, because relatively simple small machines usually cost much less than sophisticated large machines. (c) Work floor layout and work flow. Work can be laid out to promote the smooth flow of operations. Work flow is an important element in JIT, because the work needs to flow without interruption to avoid a build-up of inventory or unnecessary downtimes. Machines or workers should be grouped by product or component instead of by type of work performed. The non-value-added activity of materials movement between operations is therefore minimised by eliminating space between work stations. Products can flow from machine to machine without having to wait for the next stage of processing or return to stores. Lead times and WIP are thus reduced. (d) Total productive maintenance (TPM). TPM seeks to eliminate unplanned breakdowns and the damage they cause to production and work flow. Staff working on the production line are brought into the search for improvements in maintenance and are encouraged to take ownership of their machines and carry out simple repairs on them. This frees up CA Sri Lanka 11 CL3 | Chapter 1: Modern Manufacturing Environment maintenance specialists to use their expertise to look for higher-level ways to improve maintenance systems, instead of spending their time on fire fighting repairs and maintenance jobs. (e) Set-up reductions. Set-up is the collection of activities carried out between completing work on one job or batch of production and preparing the process or machine to take the next batch. Set-up time is non-productive time. An aim in JIT is to reduce set-up times, for example by pre-preparing set-up tasks that can be done in advance. Alternatively, set-up time can be reduced by undertaking some tasks previously not done until the machines had stopped while the machines are running. (f) Total people involvement. Staff are encouraged to take on more responsibility for using their abilities for the benefit of the organisation. They are trusted and given authority for tasks such as: (i) Monitoring and measuring their own performance (ii) Reviewing the work they have done each day (iii) Dealing directly with suppliers about quality issues and to find out about materials delivery times (iv) Dealing with customer problems and queries (v) Selecting new staff to work with them (g) Visibility. The workplace and the operations taking place in it are made more visible through open plan work space, visual control systems (such as Kanbans, described later), information displays showing performance achievements, and signal lights to show where a stoppage has occurred. (h) JIT purchasing. With JIT purchasing, an organisation establishes a close, long-term relationship with trusted suppliers, and develops an arrangement with the supplier for being able to purchase materials only when they are needed for production. The supplier is required to have a flexible production system capable of responding immediately to purchase orders from the organisation. Responsibility for the quality of goods lies with the supplier. If an organisation has confidence that suppliers will deliver material of 100% quality, on time, so that there will be no rejects, returns and hence no production delays, usage of materials can be matched exactly with delivery of materials and inventories can be kept at near zero levels. 12 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment 2.5 Elimination of non-value-added costs As you know, value is only added while a product is actually being processed. While it is being inspected for quality, moving from one part of the factory to another, waiting for further processing and held in store, value is not being added. Non-value-added activities (or diversionary activities) should therefore be eliminated. 2.6 Planning and control with Kanban Holding inventories is one source of waste in production. Not having materials or parts when they are needed is another. In other words, both having inventory when it is not needed and not having it when it is needed is wasteful practice. Kanban is the Japanese word for card or signal. A Kanban control system is a system for controlling the flow of materials between one stage in a process and the next. In its simple form, a card is used by an 'internal customer' as a signal to an 'internal supplier' that the customer now requires more parts or materials. The card will contain details of the parts or materials required. Kanbans are the only means of authorising a flow of materials or parts. The receipt of a card from an internal customer sets in motion the movement or production or supply of one unit of an item, or one standard container of the item. The receipt of two cards will trigger the movement, production or supply of two units or two standard containers, and so on. There are variants on the basic Kanban system. For example, a production system might use Kanban squares. A space is marked out on the workshop floor. When the space is empty, it acts as a signal for production to start at the previous stage. When it is full, it acts as a signal that production at the previous stage should be halted. 2.7 JIT in service operations The JIT philosophy can be applied to service operations as well as to manufacturing operations. Whereas JIT in manufacturing seeks to eliminate inventories, JIT in service operations seeks to remove queues of customers. Queues of customers are wasteful because: (a) They waste customers' time (b) Queues require space for customers to wait in, and this space is not adding value (c) Queuing lowers the customers' perception of the quality of the service CA Sri Lanka 13 CL3 | Chapter 1: Modern Manufacturing Environment The application of JIT to a service operation calls for the removal of specialisation of tasks, so that the workforce can be used more flexibly and moved from one type of work to another, in response to demand and work flow requirements. 2.8 Problems associated with JIT JIT should not be seen as a fix for all the underlying problems associated with Western manufacturing. It might not even be appropriate in all circumstances. (a) It is not always easy to predict patterns of demand. (b) JIT makes the organisation far more vulnerable to disruptions in the supply chain. (c) JIT was designed at a time when all of Toyota's manufacturing was done within a 50 km radius of its headquarters. Wide geographical spread, however, makes this difficult. 2.9 Modern versus traditional inventory control systems There is no reason for the newer approaches to supersede the old entirely. A restaurant, for example, might find it preferable to use the traditional economic order quantity approach for staple non-perishable food, but adopt JIT for perishable and 'exotic' items. In a hospital, a lack of inventory could, quite literally, be fatal, and JIT would be quite unsuitable. 2.10 Manufacturing cycle efficiency 2.10.1 Customer response time (CRT) As product life cycles shorten and customers demand quick responses to orders, organisations are seeking to improve customer response time (CRT) (the length of time between an order being placed and delivery of goods/services to the customer) and on-time delivery rate. CRT is a measure of an organisation's ability to respond to a customer's request and is in general determined by internal factors (delay between order and work starting, length of time the order spends in the production process), both of which are linked to the length of the manufacturing cycle. 2.10.2 Manufacturing cycle time (MCT) Manufacturing cycle time (MCT) is the length of time between starting and finishing the production of an order and is typically made up of: (a) Processing time (b) Waiting time 14 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment (c) Moving time (d) Inspection time Manufacturing cycle efficiency (MCE) shows (in ratio form) the proportion of time during which value is being added during the production process, and is calculated as: Processing time/(processing time + waiting time + moving time + inspection time) The closer the ratio is to 1, the more efficient the production operation. As the ratio increases: (a) WIP investment will fall (with all the associated benefits). (b) An organisation's ability to act flexibly and respond to rush orders or sudden market changes is improved. (c) Production throughput can be increased without increasing plant capacity. The need for overtime may fall or additional production may be possible without increasing fixed production costs. Reducing MCT links well with TQM (see below) because of the need to reduce reworking and inspection. However, improving MCE will increase costs. A reduction in cycle times may require the manufacturing process to be redesigned or investment in new machinery. The net benefits will very much depend on the circumstances under consideration. Will the investment required be justified by the increase in volumes or reduction in costs? Relevant costing can be used: the proportion of, say, stockholding costs which would be avoidable can be determined, perhaps by using activity-based costing. If the reduction in cycle time produces X extra additional saleable units, the opportunity cost of a cycle hour can be calculated and used to assist in the decision of whether or not to invest in reducing cycle time. 2.10.3 MCT and JIT (a) The reduction in MCT is a key phase in the introduction of JIT. (b) JIT has advantages in certain manufacturing environments, but the benefits of increasing MCE apply to all organisations, irrespective of whether they also use JIT. (c) Just as JIT can be applied to the supply chain, so too can the concept of MCE. For example, by requiring a guaranteed level of quality from suppliers, inspection time can be reduced. CA Sri Lanka 15 CL3 | Chapter 1: Modern Manufacturing Environment 2.11 Just-in-time vs Just in case Just in case is a term applied to traditional manufacturing systems used prior to the more modern approaches developed – such as just-in-time. With a just in case approach, businesses held extra inventory ‘just in case’ a problem arose. Low inventory levels Higher inventory levels Low inventory levels Higher inventory levels May have production hold-ups due to Should not have production hold ups as low inventory inventory there is required Low storage costs Higher storage costs Less working capital requirement Higher working capital requirement 3 Total quality management (TQM) In the context of total quality management (TQM), 'quality' means getting it right first time, and improving continuously. The main focus of TQM is 100% satisfaction of both internal and external customers through the continuous improvement of all activities and processes. Key elements of TQM include preventing the cause of defects in the first place (rather than relying on inspecting to a predefined level of quality) and aiming towards an environment of zero defects at minimum cost. Quality costs can be analysed into prevention, appraisal, internal failure and external failure costs and should be detailed in a cost of quality report. The essence of continuous improvement is the use of an organisation's human resources to produce a constant stream of improvements in all aspects of customer value, including quality, functional design and timely delivery, while lowering cost at the same time. 3.1 Management of quality Quality means 'the degree of excellence of a thing' – how well made it is, or how well performed if it is a service, how well it serves its purpose and how it measures up against its rivals. These criteria imply two things. (a) That quality is something that requires care on the part of the provider (b) That quality is largely subjective – it is in the eye of the beholder, the customer 16 CA Sri Lanka  CL3 | Chapter 1: Modern Manufacturing Environment The management of quality is the process of: (a) Esta