James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
After you have read and studied this chapter, you should be able to:
1. Provide concept definitions for the terms just-in-time, the theory of constraints and activity based management.
2. Discuss how each of the three terms in the first learning objective represents both a philosophy and a set of practices.
3. Describe the just-in-time elements associated with employee and management attitudes and explain how these elements differ from traditional attitudes.
4. Outline and discuss the various practices associated with just-in-time.
5. Explain how backflush costing differs from traditional cost accumulation methods.
6. Explain how backflush costing systems differ for various inventory valuation methods including absorption costing, direct costing and throughput costing.
7. Discuss the overall goal of the theory of constraints as well as the global measures and rules associated with this concept.
8. Explain the similarities and differences between just-in-time and the theory of constraints in terms of philosophy and practice.
9. Prepare income statements on a throughput costing basis and explain the behavioral implications relative to absorption costing and direct costing statements.
10. Describe and discuss two activity based management models.
11. Discuss the relationship between activity based management and the just-in-time and theory of constraints management concepts.
12. Discuss the controversial issue over whether activity based management is compatible with the just-in-time and theory of constraints philosophies.
This chapter presents an introduction to three related management systems including just-in-time (JIT), the theory of constraints (TOC) and activity based management (ABM). Each of these systems represents a broad philosophy and includes a number of techniques that tend to improve a company's profitability and competitiveness under certain conditions. While ABM is an accounting based system, JIT and TOC are production based systems. Although accounting is not the main focus of JIT and TOC, the three systems have a common link. Each of these three broad philosophies conflicts with traditional accounting theory and practice in a number of ways. The conflicts arise because the new philosophies embrace many of the characteristics of the communitarian capitalist model discussed in Chapter 1, while traditional accounting theory and practice are firmly rooted in the individualistic model. For this reason each of these management systems should be considered carefully before designing, or redesigning a cost accounting system. Our goal in studying these relatively new systems is not to become expert users of the techniques involved, but to build a foundation for evaluating the various accounting planning and control systems that we will study in subsequent chapters and that you are likely to encounter in practice.
The chapter includes four sections. The first three sections introduce the three philosophies mentioned above along with some of the techniques associated with each type of system. The fourth section includes a comparison of these three systems and addresses the question of their compatibility.
Just-in-time (JIT) has the elements of a philosophy as well as various practice elements. While the JIT philosophy is applicable to any type of organization, the practice elements apply mainly to repetitive manufacturing operations such as the production and assembly of automobiles or appliances.
Although the term Just-in-time (JIT) can be defined narrowly as a production or inventory scheduling technique, it is more frequently defined as a very broad philosophy that incorporates many of the concepts of communitarian capitalism that are outlined in Chapter 1. JIT is more appropriately thought of as a philosophy because, even though it includes a variety of techniques, it is much more than a collection of management practices. There is considerable support for the argument that successful implementation of a JIT system requires an entirely different mentality, or attitude, on the part of management and workers than the typical attitudes underlying traditional business practices and relationships. Although a precise, or operational definition of JIT has not been developed, it basically involves the elimination of waste and excess by acquiring resources and performing activities only as they are needed by customers at the next stage in the process. For example, inventory buffers are viewed as an evil in that they hide problems such as defective parts, production bottlenecks, long machine set-ups and competitive behavior within the company.
A more comprehensive definition of JIT can be developed by considering the main elements that are attributed to successful JIT systems. These elements can be separated into two broad categories including attitude and practice. While the elements of attitude can be adopted by any organization, the elements of practice are mainly applicable to companies involved in repetitive manufacturing. From an accounting viewpoint, these are companies that would normally use the process cost accumulation method.
A JIT system requires an attitude that places emphasis on the following:
1. Cooperation with a value chain perspective,
2. Respect for people at all levels,
3. Quality at the source,
4. Simplification or just enough resources,
5. Continuous improvement and
6. A long term perspective.
A JIT system also incorporates the following practices:
1. Just-in-time purchasing,
2. Focused factories,
3. Cellular manufacturing,
4. Just-in-time production,
5. Just-in-time distribution,
6. Simplified accounting and
7. Process oriented performance measurements.
A discussion of each of the elements related to attitude is provided in the following paragraphs.
A company's value chain consist of the connected set of value-creating activities that are required to produce, distribute and service a product from the initial suppliers of raw materials to the final consumer. According to Michael Porter, a company's value chain is part of a larger value system that includes the value chains of suppliers, distributors and buyers.1 Figure 8-1 illustrates the value systems for a single industry firm and a diversified firm. Each firm in the value system has a separate value chain, but these value chains are interdependent. Buyers (other companies or individuals) depend on distributors who depend on producers who depend on suppliers who in turn depend on other suppliers.
Using Porter's terminology, the value chain for a specific company starts with a generic value chain illustrated in Figure 8-2. The company's value chain includes an infrastructure made up of physical assets and various activities that support the entire chain. For example, the infrastructure includes activities such as general management, accounting, finance, legal services, and security. Other major support activities include human resource management, technology development and procurement or purchasing. A company's primary activities include inbound logistics, operations, outbound logistics, marketing & sales and customer service. Inbound logistics includes sub-activities such as transportation, receiving, inspection and materials handling. Operations involves many activities including research & development, product design, engineering, energy, planning, scheduling, production activities and maintenance. Outbound logistics refers to activities such as processing customer orders and outbound transportation. Marketing & sales activities include advertising, and sales promotion. Finally, customer service includes such activities as customer training, maintaining spare parts and repair service.
The value chain and value system concepts explicitly recognize the interrelationships, or linkages, within the economic system. Recognizing and exploiting these interdependencies is important because JIT systems depend on high levels of cooperation by everyone connected to the value chain, i.e., both inside and outside the company. Traditional systems concentrate on the value added by production activities, while the value chain perspective also includes the value added by vendors, distributors and customer service personnel. Since waste and excess are not allowed in a JIT system, everyone in the value chain must work together as a team to ensure a smooth, efficient flow of output. Advocates of the JIT philosophy point out that the competition that typically occurs between workers and departments in traditional individualistic based systems is inconsistent with the JIT concept because it produces excess that adds costs and hides problems.
Respect for People at all Levels
Most of the elements of a JIT system require that all of the constituencies (employees, customers, vendors and management) and individuals within those constituencies have a high regard for each other. Institutionalizing the concept of respect for others is not just a nice thing for a company to do, it is an important element in the JIT competitive strategy. For example, traditional management systems tend to create adversarial relationships between employees and management through a hierarchy of authoritarian supervisors. In a JIT system, workers are cross trained and empowered to make decisions that are restricted to supervisors in companies with traditional management systems. Respect tends to build the trust between employees and management that is needed to successfully implement programs for cross training and empowerment. Such programs help employees grow and bond with the company. This sequential set of outcomes produces more knowledgeable employees, fewer layers of management, lower labor turnover, higher quality and lower costs.
Quality at the source means to identify and correct problems when and where they occur. The Japanese refer to this concept as jidoka. In a JIT system, everyone in the company is responsible for quality and workers use statistical control charts and other techniques to monitor their own work. Everyone's attitude must include the idea that quality is my job, where quality is defined as conformance to specifications, as opposed to design quality.2
jidoka also includes automated inspection frequently referred to as autonomation. The idea is to make inspection part of the production process, rather than a separate activity, to insure that defective work is not moved on to the next stage in the process. The goal is to stop the production line and correct the problem at the source of the problem.
A goal of JIT systems is to achieve zero work in process inventory buffers so that products flow continuously through the system. JIT also includes the goal of zero ending finished goods inventory. This reflects the idea that JIT is a demand pull system rather than a speculative push system. Customer orders drive production. The process starts with the final consumers who place demands on the sales force, who place demands on the production facilities, who in turn place demands on upstream activities throughout the system. Although eliminating excess inventory is an important part of a JIT system, the concept is much broader than an inventory control or production scheduling method. A JIT system also emphasizes simplification and zero excess (waste) in all areas of business. The objective is for the company to acquire just enough resources including vendors, human resources, and capacity. This is a very different concept from the idea underlying traditional systems where excess resources are planned just-in-case (JIC) they are needed. The JIT view is that excess of any kind hides problems such as low quality raw materials and unreliable vendors, employees and equipment. Remove the excess and the problems become visible.
A comparison of the JIC and JIT approaches is illustrated in Figure 8-3. The ship represents the Company, the water represents the Company's resources and the rock formation symbolizes the Company's problems. In the just-in-case illustration on the left, the ship is perilously close to the rocks hidden below the surface. In the just-in-time illustration on the right, the water level is lowered (excess resources removed), revealing the rocks or problems that need to be solved.
The Japanese refer to continuous improvement as kaizen (pronounced ky'zen). To the Japanese, kaizen means to strive relentlessly to increase quality, efficiency and effectiveness in all areas of life including personal, family, social, and work. Although this concept definition may sound somewhat individualistic, the Japanese emphasize small incremental, but cumulative holistic improvements. The continuous improvement approach is illustrated by the Shewhart-Deming plan-do-check or study-action (PDCA or PDSA) cycle that appears in Figure 8-4.3 The plan step includes identifying a problem, or potential for improvement, and developing a plan for the problem's solution. The do step includes a trial run of the planned solution which is evaluated in the check step. Correctly evaluating the trial run depends on an understanding of the variation in the system. It is important not to confuse common causes with special causes of variation.4 The check step includes revisions to the plan where they appear to be needed. The final action step represents the implementation of the plan. The PDCA cycle involves using a variety of statistical tools and is a never ending activity for companies that embrace the continuous improvement methodology. Some of the statistical tools are discussed below.
PDCA Statistical Tools5
Some of the statistical tools used in the continuous improvement cycle include: 1. Pareto diagrams, 2. Fishbone, or cause and effect diagrams, 3. Histograms, 4. Other graphs and charts, e.g., pie charts, 5. Control charts and 6. Scatter diagrams and related techniques, e.g., regression and correlation analysis.
Pareto diagrams show the causes of problems in bar chart format. The idea is to graphically display opportunities for potential improvement. For example, Figure 8-5 illustrates the reasons for down time at a particular cell. These include A - Out of parts, B - Defective part, C - Equipment failure, D - Operator error and E - Power failure. Figure 8-5 reveals at a glance that nearly fifty percent of the down time is caused by a shortage of parts and another thirty percent results from defective parts.6
Fishbone diagrams show a sketch of the relationships that may contribute to a particular problem. For example, Figure 8-6 presents an abbreviated fishbone diagram for the downtime problem mentioned above. Shortages of parts and defective parts are related to vendors and delivery schedules. Equipment failures are related to the characteristics of the equipment such as age and preventive maintenance. Operator errors, on the other hand may be caused by a lack of training or experience. In other cases, the characteristics of the process may be at fault. (See another Fishbone example).
Histograms show the distribution of a performance measurement such as the number of shortages, or the number of defects, over a period of time. Figure 8-7 illustrates the number of material shortages per day for a particular period. The chart reveals that the number of shortages ranges from one to fifteen per day with eight representing the most frequent number.
Other types of graphs include pie charts and line graphs.
Piecharts are used to show the various parts of a problem, process or financial measurement in proportion to the whole. Figure 8-8 illustrates the various types of product costs in proportion to total factory costs. The idea is to emphasize the areas with the greatest potential for improvement.
Line charts are very useful for showing trends in nearly any type of measurement. For example Figure 8-9 illustrates the number of parts shortages over a fifty-two week period.
Control charts and scatter diagrams are perhaps the most important statistical tools available to aid in the PDCA continuous improvement effort. That is why they were given considerable attention in Chapter 3. Recall that control charts are used to determine when a process is stable and whether or not it is in control. Control charts are also used in the check step to reveal the success of the plan and do steps in improving the mean outcome or in reducing the variability of the process. Scatter diagrams and the related regression and correlation techniques are powerful tools for identifying cause and effect relationships. Refer back to Chapter 3 for a review of these important statistical tools.
A Long Term Perspective
Although the effect of a small improvement may seem trivial, the concept of continuous improvement becomes a powerful strategy in the long run as the cumulative benefits of hundreds, perhaps thousands of small improvements are obtained. It is somewhat analogous to an athlete training for the Olympics. The person trains daily to obtain small increases in fitness and skill. After years of cumulative incremental improvements, the athlete may reach world class status. The goal for the company pursuing continuous improvement is also to achieve and maintain a world class competitive position. Thus, a long term perspective is an essential ingredient of the JIT philosophy.
A brief discussion of each of the JIT practices is included inthe sections below.
When the concepts of JIT are applied to the purchasing function, all of the elements of attitude discussed above must be included. In addition, the adoption of JIT purchasing includes the following characteristics:
1. Establishing long term agreements with vendors on delivery and price.
2. Purchasing from a smaller number of vendors than in traditional systems.
3. Certifying vendors on quality, price and schedule attainment.
4. Increasing the frequency and reducing the size of deliveries from vendors.
5. Requiring that deliveries are made to the factory floor in shop ready containers.
6. Reducing inspection of incoming materials.
7. Emphasizing zero raw materials inventory.
8. Eliminating the warehouse space for raw materials.
The term focused factories refers to small specialized manufacturing plants that are dedicated to the production of a small number of products. This idea applies mainly to repetitive manufacturing, but companies that produce products or services to customer specifications can also become more focused by concentrating on certain types of jobs.
Cellular manufacturing refers to the practice of organizing a factory into manufacturing cells that are dedicated to the production of a single product, or a few similar products. A manufacturing cell is frequently referred to as a factory within a factory because all of the resources needed to produce the product are located within the cell. For example, instead of having many products moving through several departments such as cutting, grinding, heating, assembly and packing as in Figure 8-10, the factory is organized into separate cells for each product that include each type of machinery as illustrated in Figure 8-11. Placing the various machines close together reduces the need for inventory buffers and materials handling. The cellular arrangement also requires fewer machine operators since a single cross trained worker can operate several machines. Notice that most of the supervisors, workers, inventory and forklift trucks that appear in Figure 8-10 are not included in Figure 8-11.
The advantages of arranging the factory into cells also include obtaining more accurate product costs. Of course there is less product diversity within a cell than there is in a traditional department, but the cellular arrangement has another favorable influence on product costs. Some support services such as production scheduling, engineering, maintenance and human resource management are also decentralized which reduces the amount of indirect costs. Since these functions are performed within the cell, these costs become direct costs to the products produced in the cell. This reduces the need for first stage cost allocations for these support services and results in more accurate product costs.
JIT production is closely related to the practices of designing focused factories and organizing production operations into manufacturing cells. However, JIT production also includes several other elements that are listed below.
1. A demand pull system including kanban production control. (The term kanban is defined below.)
2. Emphasis on reducing production lead time or cycle time, i.e., time from start to finish.
3. Flexibility and short setups for the different products produced in the cell.
4. A policy of stopping the production line to correct defects, i.e., jidoka.
5. Small or zero inventory buffers.
6. Simplifying and eliminating unnecessary resources and activities, (e.g., fork lift trucks) in addition to organizing production facilities into manufacturing cells as in Figure 8-11.
7. Fail-safe devices and preventive maintenance.
The concept and practice of implementing a demand pull system means producing only what is needed by the next operation and only at the time it is needed. Producing more inventory than immediately needed is considered a form of waste. A kanban is a Japanese word meaning card. JIT production control is a manual system where kanbans, or cards are used to authorize production and the movement of materials and products within the plant7. The authorization kanbans come from demand downstream, thus inventory is pulled rather than pushed through the plant. Although the demand pull concept can be applied to a large number of companies, the kanban type inventory control system is mainly applicable in repetitive assembly manufacturing. Examples include automobiles, log-loaders, washing machines and TV sets to name a few.
JIT production also emphasizes continuously reducing the time required to perform the needed machine set-ups and operations, thus reducing down time and production lead time to a minimum. Correcting defects as they occur and emphasis on small or zero WIP inventories are closely related. Zero inventory means that there are no inventory buffers to replace defective parts. The main advantages of simplification and the just-enough-resource concept are to increase productivity, reduce costs and make problems highly visible so that they can be corrected quickly. Fail safe devices such as warning bells, timers, electric eyes and alignment templates are also used to prevent problems from occurring.8 Of course, preventive maintenance is also a must when there are no inventory buffers, since a machine breakdown can cause downtime for the entire plant.
JIT distribution systems have many of the same elements as JIT purchasing systems, except the company becomes the seller (vendor) rather than the purchaser. Some of these elements include:
1. Establishing long term agreements with customers on delivery and price.
2. Selling to a smaller number of customers than in traditional systems.
3. Becoming certified on quality, price and schedule attainment.
4. Increasing the frequency and reducing the size of deliveries to customers.
5. Making deliveries to the customer's factory floor in shop ready containers.
The advantages to the seller in a JIT system are obtained by establishing long term commitments with a smaller number of customers. This reduces costs and uncertainty. In the long run, JIT only works where everyone in the value system obtains benefits.
Some of the characteristics of JIT accounting systems include:
1. Batching deliveries.
2. Increasing the traceability of costs with fewer cost pools.
3. Reducing the need for ABC systems.
4. Reducing or eliminating cost variance analysis.
5. Backflushing inventory costs.
Since JIT purchasing involves a large number of small deliveries, these purchases are frequently recorded in batches rather than as individual purchases to simplify record keeping. Although batching deliveries may seem inconsistent with improved cost traceability, JIT increases the traceability of costs because more transactions in both the purchasing and production areas can be traced directly to the cells and the products produced in those cells. Purchasing and receiving costs decrease with fewer vendors and deliveries made directly to the plant floor. With some service functions performed at the cell level, there is less need to allocate these costs among departments in first stage allocations. In addition, since the cells are dedicated to the production of a single product, or a few similar products, there is less need for allocations in stage two. As indicated in our discussion of the two stage allocation process, if only one, or a few similar products are produced in each department, or cell, then cost distortions and cross-subsidies from cost allocations will not occur. Thus, there will be less need to develop an ABC system to obtain accurate product costs. Another characteristic of JIT accounting involves a de-emphasis on cost variances. Variance analysis and other financial results oriented measurements are replaced with a variety of process oriented measurements discussed below.
Backflush costing refers to a variety of simplified cost accumulation methods that tend to be used by companies that adopt JIT systems. Most cost systems that include the backflush method are periodic inventory systems because perpetual inventory records are eliminated. Although a single cost system that includes the backflush method is relatively easy to understand, the topic is confusing because the backflush method can be used with any inventory valuation method. To understand the possibilities, consider that there are only four main ways to account for manufacturing costs at the end of a period. The first two possibilities represent the traditional inventory valuation methods discussed in previous chapters, while the last two are non-traditional methods sometimes used by companies that adopt the JIT philosophy. The four possibilities include:
1. Capitalize all manufacturing costs in the inventory as in full absorption costing. The applicable costs of direct materials, direct labor, variable overhead and fixed overhead are deferred in the ending inventory.
2. Capitalize only variable manufacturing costs in the inventory as in direct costing, .i.e., charge fixed manufacturing costs to expense. Only the applicable direct materials, direct labor and variable overhead are deferred in the ending inventory.
3. Capitalize only direct materials costs in the inventory, i.e., charge all conversion costs to expense. Only the applicable direct materials costs are deferred in the ending inventory. This method is sometimes referred to as throughput costing because it produces the same results that are obtained in the throughput accounting method associated with the theory of constraints. Throughput accounting is explained below in the section on the theory of constraints.
4. Expense all manufacturing costs. No manufacturing costs are deferred in the inventory. This is the opposite of full absorption costing.
Although a variety of backflush systems can be designed for each of these four methods, we will consider only one system for each method. A discussion of all possible backflush accounting systems is well beyond the scope of this textbook and would not add a great deal to your understanding of the topic.
In backflush systems, the usual inventory accounts are replaced with a simplified set of accounts. Typically, the Materials and Work in Process accounts are combined into an account referred to as Raw and in Process, or RIP. The Payroll and Overhead accounts are replaced by a single account for Conversion Costs. The other accounts in the system include the familiar Finished Goods and Cost of Goods Sold (COGS) accounts. During an accounting period, purchases of direct materials, along with direct labor and overhead costs are charged to the cost of goods sold account as incurred. The usual entries are omitted including the entries to transfer the cost of goods manufactured from one department, or cell, to the next and subsequently to Finished Goods. The perpetual records illustrated in Chapters 4 and 5 are not maintained. Instead, materials and conversion costs are charged directly to Cost of Goods Sold. Then, at the end of the period, the remaining finished and partially completed units are counted and inventory costs are charged in a backward direction from COGS to Finished Goods, RIP and Conversion Cost accounts. These so called backflushed costs are usually based on budgeted or standard costs per unit.
Assume that the CM Company produces coffee makers. The budgeted manufacturing costs for the product are indicated below.
|Fixed Overhead ($6000/1,000)||6|
To keep the example simple, assume that there are no beginning inventories and that the actual costs of production are equal to budgeted costs. During the period, the Company:
1. Purchased $10,100 worth of direct materials.
2. Incurred $11,000 in conversion costs including $1,000 direct labor, $4,000 variable overhead and $6,000 fixed overhead.
3. Incurred selling and administrative expenses of $990 variable and $1,900 fixed.
4. Sold 990 coffee makers for $32 per unit.
5. Determined that the ending inventory included 5 finished units, 5 equivalent units in process and $100 worth of unused direct materials.
A backflush system compatible with full absorption costing appears in Exhibit 8-1. Note that the direct materials purchases and conversion costs are charged directly to Cost of Goods Sold. Then the costs remaining in the ending inventories are charged, or backflushed, to the RIP, Conversion Costs and Finished Goods accounts. The amount backflushed to RIP is five equivalent units at $10, plus $100 unused direct materials for $150 total. The amount backflushed to the Conversion Costs account is five equivalent units at $11 or $55. Since there are five unsold finished units, the Finished Goods account is charged with five units at $21 per unit or $105. Then, Cost of Goods Sold is $20,790 (10,100 + 11,000 - 310 or 990 units at $21) and this amount is closed to the income summary. Although this simplified system is somewhat unorthodox, the amount of cost of goods sold is exactly the same as the amount obtained in a traditional full absorption costing system. Although the accounts are different, the results are the same.
A backflush system compatible with direct costing appears in Exhibit 8-2. An additional account is needed for period costs, or factory expenses, since the fixed overhead costs are not charged to the inventory. Instead, the fixed manufacturing costs are charged directly to expense. Variable manufacturing costs of $15,100 are charged directly to cost of goods sold. Then, the amount backflushed to RIP is $150, the same as in Exhibit 8-1. However, the amount backflushed to the Conversion Costs account is only $25, (i.e., five equivalent units at $5) and the Finished Goods account is charged with only $75, (i.e., five units at $15). Then, the amount remaining in Cost of Goods Sold is $14,850 (i.e., 10,100 + 5,000 - 250 or 990 units at $15). Notice that the total amount that appears in the income summary is $20,850. This is $60 greater than the amount in absorption costing (i.e., 20,850 - 20,790). Comparing the Conversion Costs and Finished Goods accounts in Exhibits 8-1 and 8-2 reveals where the $60 difference is located. Each of these accounts contains $30 of fixed overhead in Exhibit 8-1, while all of the fixed overhead costs appear on the income summary in Exhibit 8-2.
A backflush system compatible with throughput costing is presented in Exhibit 8-3. In this illustration, only direct materials costs flow into cost of goods sold, while all conversion costs are charged directly to expense. The backflush entry involves charging $150 of the direct materials costs to RIP as in the previous two illustrations, but only $50 to Finished Goods, i.e., five units at $10. The Conversion Costs account that appears in Exhibits 8-1 and 8-2 is omitted in Exhibit 8-3 because no conversion costs are deferred in the inventory. After the backflush entry, the amount of COGS is $9,900, (i.e., 10,100 - 200, or 990 units at $10). After this amount is closed, the income summary contains $20,900 of manufacturing costs. This is $50 more than the amount that appears in the direct costing illustration in Exhibit 8-2. Of course the difference is that $50 of conversion costs are backflushed and deferred in the Conversion Costs and Finished Goods accounts in Exhibit 8-2, while these costs are charged to expense in Exhibit 8-3.
A system where none of the manufacturing costs are deferred in the inventory could be designed in a variety of ways. One such system is illustrated in Exhibit 8-4 where the entire $21,100 of direct materials and conversion costs are flushed out to the income summary, even though ten units remain in the inventory. This is not a backflush system, since none of the costs are flushed back to inventory accounts. Instead it might be referred to as a no-absorption throughput costing system since the ending materials costs are charged to expense rather than backflushed to the RIP and finished goods accounts.
Summary of Key Ideas
Although the concepts illustrated above are more fully developed in subsequent chapters, this four part example was presented to introduce a troublesome behavioral aspect of inventory valuation. A key idea to grasp is that although full absorption costing satisfies the matching concept, it tends to motivate managers to produce excess inventory. Why? Because even though total fixed manufacturing costs are relatively constant, each unsold unit soaks up some of these fixed costs. As a result, the fixed costs associated with these units appear on the balance sheet as an asset, rather than on the income statement as an expense. The higher the level of production, the greater the amount of fixed costs deferred in the inventory, the lower the amount of expense and the greater the amount of net income. Thus, critics contend that absorption costing rewards managers for producing excess. Direct costing, on the other hand, is neutral as far as building inventory is concerned because fixed manufacturing costs are expensed regardless of the number of units produced. Note that this lack of bias, or neutrality towards producing excess is more consistent with the JIT philosophy. However, the throughput costing approach goes a step further and penalizes those who produce excess by charging the conversion costs associated with the unsold inventory to expense. The no-absorption throughput method in Exhibit 8-4 maximizes the penalty for producing excess and completely reverses the full absorption costing bias.
As we shall see in the chapter on standard costing, traditional performance measurements at the cost center level place emphasis on variance analysis for material, labor and overhead. The emphasis is on measuring labor efficiency and resource utilization by comparing budgeted costs with actual costs. JIT systems de-emphasize or eliminate variance analysis, particularly at the department level, because it tends to reduce cooperation between departments and motivate managers to produce excess inventory.9 Traditional systems are criticized because they place emphasis on financial results rather that emphasizing the processes involved in obtaining those results. We will postpone our discussion of the criticisms of traditional standard cost systems until Chapter 10. The criticisms are mentioned here to highlight one of the main differences between traditional performance measurements and JIT measurements. Just-in-time measurements tend to emphasize a few key non-financial aspects of performance that are process oriented, rather than the financial results oriented measurements that are generated by the accrual accounting system. The purpose of the process oriented approach is to target the causes of a cost, or other performance result, rather than the cost, i.e., the financial performance result itself. Graphic displays of such measurements can be quite revealing when used as a guide to continuous improvement. Some examples of these measurements are provided below.
1. Vendor quality, e.g., percentage of defects.
2. Number of vendors. After implementing JIT concepts, IBM's Lexington Kentucky typewriter facility reduced the number of vendors by 95% from 640 to 32. Xerox Corporation cut its' suppliers by 94% from 5,000 to 300.10
3. Vendor percentage of on time deliveries.
4. Days of materials inventory on hand.
5. Vendor cost savings ideas implemented.
6. Cost of quality and non quality (See MAAW's Quality topic page).
The six measurements listed above are important because they reflect potential ways to reduce the overall costs associated with direct materials. These measurements represent material cost drivers recognizing that overall material costs include not only the purchase price of materials, but any costs that are associated with ordering, receiving, inspecting, unpacking, moving, storing, scheduling, reworking and returning defective parts to vendors.
1. Schedule attainment percentage. The goal is 100%.
2. Average inventory11 or days of work in process (WIP) and finished goods inventory on hand. Of course this should be low, but the absolute amount depends on the company. For example, at Hewlett-Packard's Personal Office Computer Division in Sunnyvale California, the WIP inventory level was cut from three weeks to three days when JIT concepts were implemented.12
3. Ratio of the number of units in WIP to the number of work stations or operators. A ratio of 1 indicates that buffer inventory equals zero.
4. Inventory turnover. Inventory turnover = Cost of goods sold ÷ Average inventory. Increasing the turnover is the goal. For example, at Harley-Davidson's York Pennsylvania motorcycle assembly plant, inventory turnover increased from 3.5 to 20 when JIT concepts were applied. 13
5. Measures of non-quality, e.g. defects, spoilage, rework and scrap. The goal is to obtain zero defects, spoilage and rework and minimum scrap. JIT practices helped the General Electric dishwasher plant in Louisville Kentucky cut scrap and rework by fifty-one percent. 14
6. First time through production cycle without rework percentage. The objective is 100%
7. Production cycle time or lead time = process time + inspection time + move time + storage time. The goal is to reduce production cycle time by reducing inspection, move and storage time. Omark's saw chain facility in Guelph, Ontario was able to reduce production cycle time from twenty-one days to three days within eighteen months.15
8. Ratio of process time to cycle time. A ratio of 1 would indicate that inspection, move and storage time equal zero.
9. Downtime percentage.
10. Number of line stops per day.
11. Setup time per setup.
12. Head count productivity (i.e., average output per worker = total output ÷ total employees including indirect).
13. Product costs trend analysis, e.g., percentage change in product costs.
14. Amount of space used. With a JIT plant layout, an IBM plant in Raleigh, North Carolina cut the required space from 51,000 to 9,000 square feet. 16
15. Production flow distance. Omark's log-loader plant in Prentice Wisconsin, was able to cut flow distance from 2,000 feet to 18 inches.17 In Flint Michigan, General Motors cut the flow distance for Buick fenders from 8,000 to 140 feet. 18
16. Overtime requirements and trends.
17. Number of improvements implemented.
18. Employee suggestions made and ideas implemented.
19. Employee morale.
20. Employee knowledge, such as, the average number of jobs each worker is capable of performing, or the number of job classifications. After implementing JIT, the Westinghouse semiconductor division in Youngwood Pennsylvania reduced the number of job categories by 95%.19 In a joint venture of General Motors and Toyota, (NUMMI) Toyota reduced GM's job classifications from 100 to 1 multi-skilled classification.20
1. Customer service and satisfaction.
2. Number of customer complaints.
3. On time delivery percentage.
4. Response time to customer orders. Using a highly automated JIT oriented plant, Allen Bradley's contactor facility in Milwaukee Wisconsin reduced response time from several weeks to one day. 21
Most of the measurements listed above can be monitored graphically using the statistical tools discussed in the previous section. Although not all of the performance measurements listed above are used by a single company, many JIT oriented companies maintain large displays of key measurements in various locations within the factory. The idea is to motivate employees and managers to keep up the continuous improvement emphasis by celebrating the successful effects of past PDCA efforts. The JIT performance measurement system is a very visual system.
Just-in-Time and Lean Enterprise
Before leaving this section it should be noted that companies using JIT purchasing, production, and distribution are frequently referred to in management and accounting literature as lean enterprise companies. However, Womack and Jones (who introduced the lean enterprise model in 1994), made a distinction between a lean company and a lean enterprise. A lean company is one that embraces the JIT or lean concepts and techniques described in the chapter. A lean enterprise is defined as a group of individuals, functions, and legally separate but operationally synchronized companies, all who embrace the JIT or lean organizational model. In addition, just-in-time production is often referred to as lean manufacturing or the Toyota production system. For more information related to just-in-time and lean enterprise concepts and terminology see MAAW's sections on Just-In-Time, Lean Accounting, Japanese Management Methods, Continuous Improvement, and Quality.
The theory of constraints (TOC) was developed by Eli Goldratt and originally presented in a novel entitled The Goal.22 TOC is similar to JIT in that it has elements of a philosophy as well as practice. The TOC philosophy is applicable to any type of organization, while the practice elements apply mainly to companies that produce products to customer specifications, e.g., a job shop. Examples include the manufacturers of machines, locomotives and aircraft engines.
Conceptually the theory of constraints is based on the idea that any company has identifiable constraints, thus management should identify the most binding constraints and manage them so that resources are used most efficiently. The goal is simply to make money, now and in the future. According to Goldratt, the way to make money is to maximize a global measure referred to as throughput, while minimizing two other global measures referred to as inventory and operating expense. The main idea is to focus on these global measures rather than focusing on local, or subsystem measurements. These three measurements are defined below.
Throughput is defined as sales dollars less direct materials in the products sold. More specifically, direct materials include raw materials, components and sub-components that are part of the products that are sold. Conceptually, throughput is money flowing into the system.
Inventory = assets or investment in the terminology of TOC since, from Goldratt’s perspective, everything is for sale. However, TOC product inventory (i.e., inventory in the traditional accounting sense of the term) includes only the cost of direct materials that remain unsold in the form of raw materials, work in process and finished goods. Note that the TOC definition of product inventory does not include direct labor or factory overhead costs, only direct material costs. All labor and overhead costs are expensed as in the throughput costing example illustrated in Exhibit 8-3. Conceptually, inventory is all the money inside the system.
Operating Expense is defined as the costs of converting the inventory into throughput. Operating expense includes all costs other than direct materials, e.g., direct labor and factory overhead, as well as selling and administrative costs. Conceptually, operating expense is the money flowing out of the system. See a graphic view of these global measurements.
Although the terminology associated with the theory of constraints is different from the traditional accounting terminology, the key concept of TOC is relatively easy to understand. The idea is that the sum of the local, or subsystem optimums does not equal the system optimum. Of course this is a familiar idea related to the concepts of communitarian capitalism (See Chapter 1) and the just-in-time continuous improvement philosophy.
Maximizing throughput, according to the theory of constraints, involves the following five continuous steps:
1. Identify the company's most binding constraint, i.e., the factor that places the greatest limitation on increasing throughput. This constraint may be external or internal. For example, external constraints may include a weak consumer demand, a distribution bottleneck, or a shortage of quality raw materials. Internal constraints may be capacity related. For example, a bottleneck machine or operation could represent the most binding constraint. A constraint is anything that limits throughput. (See the TOC problems for illustrations related to identifying constraints.)
2. Exploit the internal constraints by maximizing the flow of work through the constraint. The bottleneck representing the most binding constraint should never be idle because an hour lost at a bottleneck is an hour lost for the entire system. On the other hand, an hour saved at a bottleneck is an hour saved for the entire system. Why? Because it increases throughput. Therefore, inventory buffers are acceptable at a bottleneck operation to avoid downtime for the entire system. The pressure on internal bottlenecks can also be relieved by shifting some of the work to non-bottleneck operations. Of course a bottleneck operation should only be used to produce what is currently needed.
External constraints, such as weak demand are exploited by increased advertising, market promotion and developing new distribution channels, e.g., direct sales, mail order, and wholesalers. A constraint caused by a shortage of quality raw materials is exploited by actions such as locating new vendors and certifying vendors that meet standards concerning quality and delivery schedules.
3. Subordinate and synchronize the other internal constraints with the most binding constraint. This means to keep them working at the pace of the most binding constraint. The idea is to balance the flow of work, not try to balance the plant. A balanced plant refers to a theoretical situation where there is equal capacity at each operation in the plant. In the theory of constraints, a balanced plant is viewed as impossible because of the variability associated with the various processes involved. Even if the average capacity of each process or operation is the same, i.e., balanced, the inevitable variability would cause some excess capacity and a floating bottleneck. Therefore, if output from an operation is not needed downstream, it is acceptable for that operation to be temporarily idle. The action to avoid is the production of excess product or inventory buffers where they are not needed. Another way to express this idea is to say that the utilization of a non-bottleneck operation, or resource, should not be determined by it's own capacity, but by the capacity of the most binding constraint in the system. An hour saved at a non-bottleneck operation does not benefit the system. Why? Because it does not increase throughput. These three steps are referred to as the drum-buffer-rope system designed to balance the flow of work in the plant. The constraint symbolizes the drum that sets the pace, the inventory placed in front of the constraint represents the buffer that protects the pace, and the pull system represents the rope that enforces the pace.
4. Recognize the ideas above in developing performance measurement systems. The performance measurements should emphasize the efficiency and effectiveness of the total operation, or total system, not the efficiency of individual operations, or subsystems. Again, the goal is to maximize throughput.
5. Increase the capacity of the most binding constrained resource.
6. Identify the new most binding constraint, i.e., start over.
Optimized Production Technology (OPT 23)
The main ideas underlying the TOC philosophy were originally presented in a novel entitled The Goal as indicated above (See summary). Although the book is enjoyable to read, those who want a quick description of TOC may find it somewhat frustrating. The character who seems to have all the answers (Jonah the consultant) uses the Socratic approach to help enlighten the character who seems to need the answers (Alex the plant manager). Jonah gives Alex some very pointed questions, but Alex must deduce the answers for himself. (See the summary of What is This Thing called the Theory of Constraints for more on why Goldratt uses the Socratic approach).
Other books by Goldratt and Goldratt and Fox24 and a series of articles by Fox and others are more revealing. From these sources we have learned that there are ten rules associated with OPT which is the production scheduling routine, or practice part of the theory of constraints. The ten rules are listed below.
Rules That Relate to Scheduling25
1. The utilization of a non-bottleneck resource should be determined by some other constraint in the system, not the capacity of the non-bottleneck resource.
2. Activating a resource is not necessarily the same as utilizing a resource. For example, if the resource is used to produce inventory that is not needed downstream, the resource has been activated, but not utilized. Utilization refers to increasing throughput.
3. Time lost at a bottleneck is time lost for the whole system. When the bottleneck operation is down, the entire system is down.
4. Time saved at a non-bottleneck is an illusion.
Rules That Relate to Determining Batch Sizes
5. The optimum size of the process batch is not the same as the size of the transfer batch. Some units may be moved as needed by the next operation (to balance the flow), before the entire batch is finished.
6. The process batch size should not be fixed, but should vary from one machine to the next. Again the idea is to balance the flow of work.
7. The capacity of the various operations and the priority of the jobs should be considered simultaneously. The main idea conveyed by this rule is that the variability within each operation needs to be considered when scheduling production because the combination of statistical fluctuations (variability) and dependent events tends to cause floating bottlenecks . The capacity of each operation should be defined in terms of a distribution of performance, not just a mean, or an upper limit. Scheduling in OPT is performed by a proprietary program referred to as "the brain". This scheduling algorithm is designed mainly for job shops where a simple kanban approach is not feasible.
8. Potential problem areas can be identified and minimized. For example, providing a buffer inventory at a bottleneck protects the bottleneck from problems upstream in the production process.
Rules That Relate to Performance Measurements
9. Do not attempt to balance the plant because a balanced plant is theoretically impossible due to the random variation associated with each operation and process. Attempting to balance the plant will cause floating bottlenecks and make it difficult, it not impossible, to manage the plant (See the Match Bowl or Dice Game note).
10. Do not try to optimize the output of each separate work center because this will only insure sub-optimization of the system. Trying to produce as much as possible at each operation will cause some work centers to produce inventory that cannot be turned into throughput by the system, i.e., they will be activated, but not utilized.
Applying the concepts and rules of the theory of constraints has helped many companies dramatically improve performance. For example, using the TOC approach ,Valmont/ALS, a job shop steel fabricator in Brenham Texas, increased income by 154 percent even though sales decreased by 2 percent. These results were obtained by simultaneously increasing inventory turnover by 39 percent and decreasing operating expenses by 17 percent.26
As indicated above, the TOC approach treats all costs, other than direct materials, as operating expenses, or period costs. Therefore, product inventory costs (i.e., work-in-process inventory and finished goods inventory) and direct materials costs are synonymous in the TOC methodology. To strengthen your understanding of this method, consider the throughput costing illustration presented in Exhibit 8-5. The CM Company example used earlier in the backflush illustrations is used again for comparative purposes.
Observe from Exhibit 8-5 that although the final results are the same as in the throughput costing backflush system illustrated in Exhibit 8-3, direct materials costs flow through the inventory accounts in a more conventional way. Purchases of $10,100 are charged to the RIP account. Then $9,950 is transferred to finished goods representing the 995 completed units at $10 per unit. The cost of the 990 units sold is transferred from finished goods to the COGS account and then this $9,900 is closed to the income summary. Conversion costs are charged to operating expense, or period costs and subsequently closed to the income summary as in Exhibit 8-3. This series of entries leaves $150 in the RIP account, $50 in finished goods and $20,900 on the income summary. Note that these are the same amounts that are obtained in the backflush system in Exhibit 8-3.
Abbreviated income statements are presented in Exhibit 8-6 to provide a comparison of throughput costing with the traditional inventory valuation methods. Of course, sales of $31,680 (990 units at $32) are the same in each statement. Selling and administrative expenses (S&A) of $2,890 are also the same in each statement, although the variable and fixed expenses are separate in direct costing. The key differences between the three statements involve the amounts for cost of goods sold, the terminology and the amounts for operating income. Cost of goods sold is $21 per unit in absorption costing ($10 of direct material plus $11 of conversion costs), only $15 per unit in direct costing (i.e., the $6 for fixed overhead is excluded) and $10 in throughput costing, (i.e., excluding the $11 of conversion costs). The COGS amounts appear in Exhibits 8-1, 8-2 and 8-3 or 8-5.
Referring to Exhibit 8-6, observe that Sales less COGS represents throughput in the throughput costing statement while the familiar terms gross profit and manufacturing margin are applicable in the absorption and direct costing statements. Comparing operating income across the three statements reinforces the conceptual differences discussed earlier in the backflush examples. The differences in operating income can be reviewed quickly by examining the ending inventory amounts in Exhibits 8-1, 8-2 and 8-3 or 8-5. The amounts deferred are $310 in absorption costing, $250 in direct costing and only $200 in throughput costing. Of course the differences in the amounts deferred explain the income differences. For absorption and direct costing they are 310 - 250 = 8,000 - 7,940 = $60. For direct and throughput costing they are 250 - 200 = 7,940 - 7,890 = $50.
If the $200 of ending direct materials costs were closed (flushed) to expense, then the throughput costing statement would show $11,200 for factory operating expenses and $7,690 for operating income. This result conforms to the no-absorption example in Exhibit 8-4.
Comparative Income Statements
|Absorption Costing||Direct Costing||Throughput Costing|
|Less COGS:*||Less COGS:**||Less COGS:***|
|105||20,790||Less EFG||75||14,850||Less EFG||50||9,900|
|Gross profit||10,890||Manf margin||16,830||Throughput||21,780|
|Less S&A expense||2,890||Less Var S&A||990||Less Oper Expense:|
|Operating Income||$8,000||Contribution margin||15,840||Factory||11,000|
|Less Fixed costs||7,900||S&A||2,890||13,890|
|Operating Income||$7,940||Operating Income||$7,890|
|See the Exhibit 8-6 Cost of Goods Sold Calculations *, **, and ***.|
The behavioral implications associated with the three methods are fairly easy to see. First, consider that the direct costing statement reveals the amount of operating income that will result under each of the three methods when the number of units produced is equal to the number of units sold. In the CM Company example, 1,000 units are produced (995 finished units, plus five equivalent units in process), but only 990 units are sold. If only 990 units had been produced, each statement would show operating income of $7,940. However, the inventory increase of ten units caused absorption costing income to be $60 greater than it would have been if the company had produced only 990 units and caused throughput costing income to be $50 less. From the JIT or TOC point of view, absorption costing provides the wrong signal, i.e., produce more, while throughput costing provides the right signal, i.e., produce only what the company can sell. For more information related to the theory of constraints see MAAW's TOC section.
The concept of activity based management (ABM) evolved from the CAM-I conceptual design discussed in the Chapters 1 and 7 and the contributions of many practitioners and researchers. As indicated in the brief discussion of the concept in Chapter 1, ABM is a broad umbrella term that includes activity management, activity costing and activity based product costing, as well as many of the concepts associated with just-in-time and the theory of constraints. From an accounting perspective, activity based management represents the potential connection between accounting and the JIT and TOC philosophies. ABM represents an attempt to integrate all of the new accounting and management concepts into one effective system. Although ABM has been defined in a number of ways, we will look at two important models of ABM that are conceptually different. For convenience we will refer to them as the Johnson model and the CAM-I model.
An activity based management model is presented in Figure 8-12 based on a framework provided by H. Thomas Johnson.27 There are six key elements in Johnson's ABM model. As illustrated in the previous chapter, activity costing includes: 1) defining activities, 2) identifying the activity drivers and measures to represent them and 3) assigning costs to these activities. Activity based product costing adds the fourth element that involves using the activity measures to assign the activity costs to cost objects such as products, services, distribution channels and customers. Activity management includes the first two elements, essentially ignores elements 3 and 4, i.e., the financial, or cost elements, and adds two process oriented elements. These include 5) the development of non-financial performance measurements and 6) using these measurements to monitor the company's continuous improvement efforts. The emphasis on the right-hand side, or cost side, of Figure 8-12 is on providing cost information for the strategic management decisions discussed in the previous chapter, (e.g., product pricing etc.) while the emphasis on the left-hand side, or process side, is on eliminating waste and improving processes, products and services from the customers point of view. The activity management elements 1, 2, and 5 provide a basis for understanding the processes and work performed within the company. This understanding is a prerequisite for using the plan-do-check-action continuous improvement approach illustrated in Figure 8-4. The PDCA approach and other tools (e.g., control charts etc.) are part of element 6.
There is one key idea in Johnson's framework that separates it from traditional accounting control systems. The process side of the ABM model is not connected to the cost side at the bottom in Figure 8-12. The performance measurements (Element 5) that are used to manage processes (Element 6) are not financial, or cost-based measurements. Johnson emphasizes that the idea is to manage activities, not costs. Why? Because managing costs tends to lead to dysfunctional behavior, such as reducing needed expenditures for training and maintenance. On the other hand, managing activities places the emphasis on working continuously to reduce waste and improve customer value. This is the potential link from activity based accounting to the JIT philosophy, but in Johnson's model it is not a direct link because the accounting elements in Figure 8-12 (i.e., elements 3 and 4) are not part of the activity management subsystem.
A different illustration of the ABM model is provided in the CAM-I glossary of activity based management.28 A similar illustration is presented in Figure 8-13. This illustration mainly emphasizes the difference between ABC and ABM. Although the ABC model is one dimensional, the ABM model is two dimensional. The vertical view in Figure 8-13 is referred to as the cost assignment dimension of activity based costing. This is the same view of ABC presented in Figure 7-1 in the previous chapter. However, moving from ABC to ABM requires adding the horizontal view , or process dimension. Managing activities requires analyzing the processes within each activity and developing performance measurements to monitor the company's continuous improvement efforts.
ABM includes the strategic cost information provided by ABC for decisions such as product introduction, product pricing, make versus buy, product discontinuance and investment management. But ABM also includes nonfinancial, process oriented information needed to measure and monitor the sources of competitive value.
Although the CAM-I and Johnson models may appear to be consistent from the illustrations in Figures 8-12 and 8-13, there is a fundamental difference. In the CAM-I model, both nonfinancial information and cost information are used to manage activities29, while in the Johnson model, cost information is excluded for this purpose. Figure 8-12 can be revised to represent the CAM-I model by simply adding lines from activity costing to elements 5 and 6 as illustrated in Figure 8-14. However, from Johnson's perspective, this is not a good idea.30
The conflict between the Johnson and CAM-I models cannot be resolved in a textbook. However, any company that contemplates changing from a traditional cost-based control system, to a system compatible with the JIT and TOC philosophies should consider whether nonfinancial information can coexist with financial information at the activity management level. In other words, can a balanced performance measurement system be developed where managers do not over emphasize either the nonfinancial or financial side of the business?
For more information on activity based management see MAAW's ABM section.
Philosophically JIT, TOC and ABM are much the same. All three concepts emphasize continuous improvement by systematically removing waste from the system. However, from a practice perspective these concepts are quite different. Just-in-time emphasizes focused factories, a cellular plant layout and kanban inventory control. These practice elements are applicable in repetitive production or assembly operations. The theory of constraints, on the other hand, emphasizes a scheduling algorithm that balances the flow of work through a job shop with the inevitable bottlenecks and other constraints. While JIT places emphasis on zero inventories, TOC allows for inventory buffers at bottleneck operations. However, this does not represent a conflict between the two approaches because the manual kanban system and the TOC computer scheduling routine are not competing. The JIT kanban system is applicable in a continuous flow, or process environment, while the TOC scheduling algorithm is applicable in a job order environment. Both JIT and TOC emphasize a simplified accounting system. A variety of simplified backflush accounting methods evolved from the JIT concepts, while throughput accounting was developed from the theory of constraints. The combination of these two ideas produces a throughput costing backflush system (See Exhibit 8-3) that is consistent with both philosophies because it encourages managers to produce only what is needed. Although JIT and TOC are different, there appear to be no fundamental conflicts between the underlying philosophies or practices.
Although activity based management includes the continuous improvement concept, the main practice element of ABM focuses on activity accounting, i.e., activity costing and activity based product costing. Therefore, activity based management is also accounting based management. As we learned in Chapter 7, ABC (the cost assignment dimension of ABM) generates accurate product costs by tracing costs to activities and from activities to products using a variety of activity measures. This enhanced emphasis on accounting creates a fundamental difference between ABM and the other two approaches. JIT and TOC both focus on improving the company's processes, reducing waste and balancing the flow of work. Accounting is not the center of attention. In fact, accounting plays a diminished role in JIT and TOC systems. Accurate product costs are obtained in JIT through a focused plant, cellular layout and decentralized services. On the other hand, product costing appears to be a non-issue in the theory of constraints where the goal is to simultaneously increase throughput while reducing inventory and operating expenses.
This discussion has lead us to an interesting and very important controversial question. Are JIT and TOC production and simplified accounting systems compatible with ABM? Some of the arguments on each side of this issue are provided below.
Critics of activity based costing contend that reorganizing a factory into dedicated cells that are focused on producing a few similar products eliminates the need for elaborate ABC systems. Simplified backflush systems satisfy the accounting requirements, therefore using ABC with JIT is just a another form of waste. While ABC may provide more accurate product costs in a TOC job shop environment, the risk of overemphasizing financial measurements at the expense of non-financial measurements is too great. The performance measurement system should place emphasis on managing the processes and work that people do, not on the financial results. If the cost accounting system is the center of attention, managers will be distracted from the critical success factors such as cycle time, quality, flexibility and responsiveness to customer needs.
Proponents of ABM argue that the JIT and TOC continuous improvement concepts are important and are part of the ABM methodology. However, although JIT practices are designed to improve processes, cycle time, quality and other aspects of performance, they cannot replace, or eliminate the need for management decision support systems. Activity based product costing provides the information needed to determine which products, distribution channels and customers are profitable. Activity costing helps identify where the greatest benefits can be obtained from PDCA continuous improvement efforts. In addition, activity costing reveals the financial consequences of those improvements. Backflush costing and non-financial performance measurements cannot satisfy these needs. ABM provides the potential for a balanced integrated system that can supply all of management's information needs.
Although it is not likely that this controversial issue will be resolved in the near future, there are some survey and case study results indicating that ABC can coexist with the lean enterprise concepts. For example, in a survey conducted by David Galley of General Motors, seventy-eight of the ninety manufacturing plants that used ABC also used JIT.32 These survey results may appear to provide strong support for the view that ABC is consistent with JIT. However, these results do not indicate the extent to which non-financial and financial measurements were integrated for the purpose of activity management. It is possible that many, perhaps most, of these companies do not mix ABC with JIT. As indicated in Chapter 7, the majority of ABC systems reported have been stand alone microcomputer based applications that are designed to support intermediate term strategic decisions such as pricing and product mix. On the other hand, JIT systems tend to be real-time visual systems designed to support day to day operations. For most companies, an operational ABM model may look more like the compromise model in Figure 8-15 where dotted lines replace the solid lines from elements 5 and 6 to the activity costing subsystem. This revision in the model symbolizes that activity based cost information is useful for identifying potential improvements, but not dominant for process performance measurement purposes. The key to developing effective performance measurement systems is the explicit recognition that the dominant measurement will simultaneously measure and influence performance. While this is not a new idea, it is becoming more important as an increasing number of companies embrace the team oriented, system oriented, lean enterprise concepts. Although the potential for conflict between accounting based measurements and the lean enterprise concepts of JIT and TOC will always exist, a conflict is not inevitable if systems designers can effectively incorporate the interactive nature of behavior and measurement into their models. (See the Survey topic for more recent survey results).
The purpose of the Flo Toy demonstration, or game33, is to facilitate a classroom demonstration to show the difference between the just-in-time pull system and the traditional push system. In the JIT pull system everyone works together as a team. In the traditional push system everyone works as an individual.
The product is referred to as a Flo Toy and is something that a child might play with in the bath tub. It includes two styrofoam cups that are taped together. However, assembly includes placing a red dot on one cup, a blue on the other cup and then an operation to tape the cups together.
There are six or seven workers on a team depending on whether the team is demonstrating a push system or a pull system.
1. A material handler.
2. A direct laborer that places a red dot on cups.
3. A direct laborer that places a blue dot on cups.
4. A direct laborer that tapes the cups (one red dot and one blue dot) together.
5. A packaging/shipping person.
6. Inspector in push system, but not in pull system.
7. A record keeper. Keeps measurements on board. (See below)
The material handler supplies workers 2 and 3 with cups and moves the completed products (cups with dots) to worker 3. The demonstration might also include a customer, perhaps a wholesaler.
The demonstration could include two production or assembly lines, (one based on a push system and the other based on the JIT pull system) or the same group could start with the push mindset and then switch to the pull mindset.
Rules for the Push System Line
1. Each person works as hard as they can to produce.
2. No one interferes with the other workers' performance.
3. Each worker attempts to produce as much as possible and push it to the next work station to meet a quota or to obtain incentive pay. Everyone ignores defects, i.e., off size cups, except the inspector.
4. Worker speed and efficiency is the main performance measurement.
5. Individual excellence is important.
Rules for the JIT Pull System Line
1. Each worker produces only what is needed by the next station, i.e., only when the next worker's kanban is empty. (Some
colored paper could be used to indicate the kanbans).
2. Each worker pays attention to any trouble the other workers are having and helps them out when they have idle time.
3. Performance is evaluated on the basis of the output of the group, not the individual. Performance is based on a.) amount of inventory in the system, b.) cycle time, c.) amount of rework, d.) product quality and e.) teamwork.
4. Stop if a defect is found, i.e., do not work on off size cups. Quality is every workers job. There is no inspector.
Record keeper for each system.
1. Measure the cycle time. Mark a unit of raw material (cup) and time how long it takes to get to finished goods.
2. Measure product quality.
3. Measure teamwork. (Subjective)
4. Measure total output.
5. Measure total inventory in work in process and finished goods at the end of the designated time.
6. Also measure customer satisfaction if there is a customer.
1 These concepts are discussed in depth by Porter, M. 1985. Competitive Advantage. The Free Press; and Porter, M. E. 1998. Competitive Advantage: Creating and Sustaining Superior Performance. The Free Press. John Shank was instrumental in popularizing the value chain concept in Accounting. See Shank, J. 1989. Strategic cost management: New wine, or just new bottles? Journal of Management Accounting Research (Fall): 47-65. For more on the value chain see Donelan, J. G. and E. A. Kaplan. 1998. Value Chain Analysis: A Strategic Approach To Cost Management. Journal of Cost Management (March/April): 7-15. (Summary). See the Business Flow Chart illustration for a similar idea.
2 A Chevrolet automobile reflects high conformance quality if it meets the specifications of a Chevrolet. Higher design quality is reflected by the design specifications of a Cadillac automobile. However, a Cadillac could have lower conformance quality than a Chevrolet if the Cadillac did not conform to Cadillac design specifications. See Morse, W. J. 1983. Measuring quality costs. Cost and Management (July-August): 16-20. (Summary).
4 Recall from Chapter 3 that variation resulting from common causes represents the predictable random variation in a stable system. An improvement represents a favorable change in the mean outcome, or a reduction in the random variation within the system.
5 The five tools presented in this section and several others are discussed by Imai in Kaizen: The Key To Japan's Competitive Success. (Summary). For other illustrations, see Hayes, R., S. Wheelwright and K. Clark. 1988. Dynamic Manufacturing: Creating the Learning Organization. New York: The Free Press; and Schonberger, R. 1990. Building a Chain of Customers: Linking Business Functions to Create The World Class Company. The Free Press.
6 For an expanded application of the Pareto concept see Tatikonda et.al., 1999. Succeeding with 80/20 rule. Management Accounting (February): 40-44.
7 The kanban system was developed by Taiichi Ohno at Toyota Motor Company in 1952. See Toyota. 1998. The Toyota Production System: Leaner Manufacturing for a Greener Planet. The Toyota Motor Corporation (Summary). While the terms kanban and Toyota system are common in Japan, American companies use a variety of other terms for their demand pull type production systems. For example, the Weatherford plant of 3M Company uses the term "Nip and Tuck" while Omark Industries refers to their system as "ZIPS" (Zero Inventory Production System). See Imai, Kaizen: 87 (Summary) and Waters, C. R. 1984. Why everybody's talking about just-in-time. INC (March): 77-90; and Bailes, J. C. and I. K. Kleinsorge. 1992. Cutting waste with JIT. Management Accounting (June): 28-32. For more on Oregon Cutting System's (formerly Omark) use of JIT concepts see Bailes, J., I. Kleinsorge and L. White. 1992. How support services can use process control. Management Accounting (October): 45-51.
8 The Japanese refer to the use of fail safe devices or mistake proofing as pokayoke. See Chase, R. B. and D. M. Stewart. 1994. Make your service fail-safe. Sloan Management Review (Spring): 35-44.
9 Several illustrations in subsequent chapters reveal why this is true, including Chapters 9, 10 and 12.
10 See Schonberger, R. J. 1986. World Class Manufacturing. The Free Press: 232 and 235. For a comparison of traditional batch measurements versus JIT (lean enterprise) measurements see Schonberger, R. J. 2003. How lean/TQ helps deter cooking the books. Journal of Cost Management (May/June): 5-14. (Summary).
11 If the inventory levels do not fluctuate a great deal from month to month, the average inventory is based on the sum of the beginning and end of year inventories divided by 2. If there is a great deal of variation in inventory levels from month to month, then a better measure of the average inventory is found by summing the monthly beginning inventories plus the end of year inventory and dividing by 13.
12 See Schonberger. 1986. World Class Manufacturing: 229.
13 See Schonberger. 1986. World Class Manufacturing: 233.
14 See Schonberger: 1986. World Class Manufacturing: 230.
15 See Schonberger: 230. Also see Schonberger, R. J. 1987. World Class Manufacturing Casebook: Implementing JIT and TQC. New York: The Free Press: 34.
16 See Schonberger. 1986. World Class Manufacturing: 231.
17 See Waters, C. R. 1984. Why everybody's talking about just-in-time. INC (March): 77.
18 See Schonberger: 1986. World Class Manufacturing: 234
19 See Schonberger: 1986. World Class Manufacturing: 233.
20 See Hof, R. D. and J. B. Treece. 1989. The team-up has it all - Except sales. Business Week (August 14): 79.
21 See Schonberger. 1986. World Class Manufacturing: 234.
22 See Goldratt, E. M. and J. Cox. 1984. The Goal: A Process of Ongoing Improvement. North River Press. Revised editions were published in 1986 and 1992. (Summary); Goldratt, E. M. 1990. What is this thing called Theory of Constraints. New York: North River Press. (Summary).
23 OPT is a trademark of Creative Output Incorporated.
24 See Goldratt, E. M. and R. Fox. 1986. The Race. New York: North River Press; Goldratt, E. M. 1990. What is this thing called Theory of Constraints and how should it be implemented? New York: North River Press. (Summary); and Goldratt, E. M. 1990. The Haystack Syndrome: Sifting Information Out of the Data Ocean. New York: North River Press. (Summary).
25 The ten rules are discussed by Fox, B. 1982. OPT-answer for America part II. Inventories & Production (November/December): 10-19.
26 See Koziol, D. S. 1988. How the constraint theory improved a job-shop operation. Management Accounting (May): 44-49.
27 See Johnson, H. T. 1989. Professors, Customers and Value: Bringing A Global Perspective To Management Accounting Education. Proceedings of the Third Annual Management Accounting Symposium (American Accounting Association). (Summary); and Johnson, H. T. 1992. Relevance Regained: From Top-Down Control to Bottom-up Empowerment. New York: The Free Press. (Summary).
28 See Raffish, N. and P. B. B. Turney. 1991. Glossary of activity-based management. Journal of Cost Management (Fall): 53-63. For some recent improvements in the CAM-I model see Euske, K. J. and A. Vercio. 2007. Enhancing the ABC cross. Management Accounting Quarterly (Summer): 48-61.
29 See Turney, P. B. B. 1991. Common Cents: The ABC Performance Breakthrough. Cost Technology: 89, 140 and 217.
30 For more on Johnson's ideas see Johnson, H. T. 1990. Beyond product costing: A challenge to cost management's conventional wisdom. Journal of Cost Management. (Fall): 15-21. (Summary). In addition, see MAAW's Relevance Regained topic.
31 For the sources of some of the arguments on each side of this issue, see Martin, J. R. 1994. A controversial-issues approach to enhance management accounting education. Journal of Accounting Education (Winter) 59-75. (Summary).
32 See Cooper, R. 1994. The role of activity-based systems in supporting the transition to the lean enterprise. Advances In Management Accounting. (3): 1-23; Cooper, R. 1996. Activity-based management and the lean enterprise. Journal of Cost Management (Winter): 6-14. (Summary).
33 This demonstration is based on a presentation made by John Y. Lee at the Western Regional meeting of the American Accounting Association in May 1991.
(See the JIT questions for a longer, but similar set of questions with links to find answers.)
1. Define the "Just-In-Time" concept.
2. Is "Just-In-Time" a philosophy or just a collection of techniques? Explain your answer.
3. Explain the difference between a value system and a value chain.
4. How does the value chain concept differ from the traditional value added concept?
5. Discuss the value chain in terms of the concepts of cooperation and teamwork.
6. What do we mean by the term "quality at the source"?
7. What is the difference between design quality and quality of conformance
8. Compare the concepts of Just-In-Time (JIT) and Just-In-Case (JIC) in terms of the acquisition and utilization of resources.
9. Discuss the JIT and JIC concepts in terms of concealing and exposing problems.
10. Discuss the concept of continuous improvement and the Sheward-Deming Plan-Do-Check-Action (PDCA) cycle.
11. Describe several statistical tools used to achieve continuous improvement.
12. List several of the JIT practices that can be applied to the purchasing function.
13. Why would a company want to reduce the number of it’s vendors or suppliers?
14. How does the relationship between a company and it’s suppliers change when the companies convert from a traditional relationship to a JIT relationship?
15. How do the suppliers benefit from JIT purchasing?
16. What is a focused factory?
17. What does the term "cellular manufacturing" mean?
18. How does cellular manufacturing tend to reduce costs?
19. How does cellular manufacturing tend to improve product costing?
20. List several of the JIT practices that can be applied to the production function.
21. Explain the difference between a demand pull production system and a push system.
22. List some of the characteristics of a JIT accounting system.
23. What do we mean by the term "backflush costing"?
24. What does the term "throughput" mean and what is "throughput costing"?
25. Briefly compare the behavioral implications associated with traditional inventory valuation methods and throughput costing.
26. Discuss the difference between traditional performance measurements and JIT measurements.
27. List some of the JIT performance measurements related to purchasing.
28. List some of the JIT performance measurements related to production.
(See the TOC questions for a much longer set of questions with links to find answers.)
29. Discuss the Theory of Constraints (TOC) in terms of the related concepts of throughput, inventory and operating expense. (See The Global Measurements of TOC).
30. What are the five steps associated with TOC? (See The Five Continuous Steps).
31. What is "Optimized Production Technology" or OPT?
32. Compare JIT and TOC. (See the ABM questions for a longer, but similar set of questions with links to find answers.)
33. How does Activity Based Management (ABM) differ from Activity Based Costing (ABC)?
35. Are the concepts of JIT and TOC compatible? Explain your answer.
36. Is the ABM concept compatible with JIT and TOC? Explain your answer. (See Controversial Issue).
37. If a company changed from a traditional plant layout and production system to a just-in-time plant layout and production system, there would be no need for activity based costing? Comment.
38. Is a JIT production system more like job order costing or process costing? Explain.
39. Are the concepts of JIT and TOC applicable to a job cost system?
40. How does converting from a traditional purchasing system to a JIT purchasing system reduce purchasing and receiving costs?
41. How does converting from a traditional production system to a JIT production system reduce costs?
42. Switching from a traditional system to a JIT system involves several changes including a physical change in the plant layout, a change in the relationships with suppliers and customers (internal and external), and a mental change on the part of management and workers? Briefly discuss the mental changes needed. Which type of change (physical or mental) do you think would be the most difficult to achieve? Why?
(The following article is helpful in answering the previous question and several of the other questions above. Goodson, R. E. 2002. Read a plant - fast. Harvard Business Review (May): 105-113. (How the rapid plant assessment (RPA) process can tell you if a factory is truly lean in as little as 30 minutes. The process includes two tools: The RPA rating sheet includes 11 categories for assessing leanness, and the RPA questionnaire includes 20 yes or no questions). (Summary).
43. Relate the JIT, TOC and ABM concepts discussed in this chapter to the two types of capitalism discussed in Chapter 1.
Match the following statistical tools with the appropriate descriptions.
1. Pareto diagram.
2. Fishbone diagram.
4. Line graph.
5. Control chart.
6. Scatter diagram.
A. A graphical display showing trends.
B. A bar chart showing how the frequency of a problem measurement is distributed over time.
C. A graph used to measure variability.
D. A bar chart showing the frequency of different types of problems.
E. A graphical technique used to identify cause and effect relationships.
F. An illustration showing the causes of a particular type of problem.
Match the traditional push system (A) and JIT pull system (B) with the following characteristics.
1. Maintaining large inventories of work in process and finished goods.
2.Vendors deliver materials to the area in the plant where they will be placed into production.
3. Greater emphasis on interdependencies between production areas.
4. Greater emphasis on individual performance.
5. Large well stocked warehouse.
6. Tend to emphasize departmental idle capacity variances.
7. Emphasis on quality at the source.
8. Emphasis on producing products as needed by the next operation or customer.
9. Emphasis on maximizing the output of each worker.
10. Emphasis on visual measurements to authorize production and monitor performance
Match the manufacturing traditional system (A) and JIT system (B) with the concepts and characteristics below.
1. Tend to emphasize specialized workers rather than cross-trained workers.
2. Small number of suppliers.
3. Little or no inspection of incoming raw materials.
4. Purchase large quantities of raw materials to receive quantity discounts.
5. Many small deliveries from suppliers.
6. Arrange equipment in the production sequence rather than by functional area.
7. Use top down management with many supervisors.
8. Emphasize fail safe devices to eliminate defects and spoilage.
9. Emphasize large production batch sizes to minimize machine setup cost per unit.
10. Tend to decentralize support services.
Using the list below, identify the cost generating activities that you believe would be reduced when a company changes from a traditional manufacturing system to a JIT system. Explain how or why each of the activities you choose would decrease.
Unpacking incoming shipments.
Counting and inspecting.
The paperwork involved, e.g, filling out the receiving report.
Moving and Handling Activities:
Moving materials from receiving to warehouse.
Moving materials from warehouse to production areas.
Moving materials between producing departments.
Moving materials from finishing to warehouse.
Storage Activities and Costs:
Pickers and other materials handlers.
Match JIT (J) and TOC (T) with the following concepts or characteristics.
1. More applicable to a process cost environment.
2. More applicable to a job order cost environment.
3. Allows for some inventory buffers.
4. Emphasis on a manual inventory control system.
5. Uses a computer scheduling algorithm.
6. Uses throughput accounting.
7. Uses manufacturing cells.
8. Defines inventory costs in terms of direct materials only.
9. Was developed in Japan.
10. Was developed by Eli Goldratt
Assume that the ARTPRO Company produces a product with budgeted manufacturing costs as indicated below.
|Fixed Overhead ($200,000/10,000)||20|
There are no beginning inventories and the actual costs of production are equal to budgeted costs. During the period, the ARTPRO Company:
1. Purchased $402,000 worth of direct materials.
2. Incurred $400,000 in conversion costs including $50,000 direct labor, $150,000 variable overhead and $200,000 fixed overhead.
3. Determined that the ending inventory included 300 finished units, 200 equivalent units in process and $2,000 worth of unused direct material.
Part I. Assume that the ARTPRO Company uses a backflush system based on full absorption costing. The company charges all manufacturing costs to cost of goods sold as incurred. At the end of the period a backflush entry is made to charge an appropriate amount of cost to the raw and in process (RIP), conversion costs and finished goods accounts. The RIP account is used only for materials. Record the following using T-accounts or journal entries:
1. The material purchases during the period.
2. The conversion costs incurred during the period.
3. The backflush entry needed at the end of the period.
Part II. Record the same entries as in Part I except assume the company uses a backflush system based on direct costin
Part III. Record the same entries as in Parts I and II except assume the company uses a backflush system based on throughput costing.
Part IV. Assume that the ARTPRO Company sold 9,500 units during the period at $100 per unit and that selling and administrative expenses are $50,000 ($30,000 fixed, 20,000 variable). Calculate operating income for each of the three cost systems above and explain the difference.
1. Which of the following statements is true? Both ABC and JIT
a. place emphasis on simplification.
b. provide more accurate product costs than traditional systems.
c. emphasize quality improvements.
d. all of the above.
e. none of the above.
2. Which of the following concepts or techniques is (are) consistent with the JIT philosophy?
a. Using statistical control charts at the process level.
b. Using a team approach to performance measurements.
c. Using overhead variance analysis at the process level.
d. a and b.
e. a and c.
3. Which of the actions stated below is not consistent with JIT purchasing?
a. Reduced inspection of incoming materials.
b. More frequent deliveries from vendors.
c. Long term agreements with vendors.
d. Vendor certification and education on quality requirements.
e. Increased number of vendors to obtain competitive prices.
4. A JIT production system would not include an emphasis on
a. maximizing the quantity of output at each stage of the production process.
b. producing products as needed by the next stage of the production process.
c. decentralization of support services.
d. a and b.
e. a and c.
5. In the language of JIT which two of the following terms refer to finding and correcting defects as they occur?
a. kaizen and jidoka.
b. autonomation and kanban.
c. kaizen and kanban.
d. Kanban and jidoka.
e. jidoka and autonomation.
6. Departmental overhead rates are likely to be
a. more accurate in a just-in-time production system than in a traditional production system.
b. more accurate in a traditional production system than in a JIT system.
c. equally accurate or inaccurate in both systems.
d. used in a traditional system but not in a JIT system.
e. None of the above.
7. The value chain concept refers to the linked set of value adding activities performed
a. within an organization.
b. within an organization, plus the capital added by stockholders.
c. from suppliers through an organization's production activities.
d. from suppliers through an organization's distribution activities.
e. from suppliers through an organization's customer service activities.
8. Rearranging a factory from a traditional layout to a cellular layout tends to
a. reduce the need for inventory buffers.
b. reduce the number of machine operators needed.
c. convert some indirect product costs to direct product costs.
d. a and b.
e. all of the above.
9. Activity based management (ABM) includes six elements: 1. Define activities, 2. identify drivers and activity measures, 3. assign costs to activities, 4. assign costs to cost objects such as products, 5. develop performance measurements and 6. manage processes and work. Which of these elements are part of "activity management" according to H. Thomas Johnson’s ABM framework?
a. 1 through 6.
b. 1 through 4.
c. all but 4.
d. all but 3 and 4.
e. only 5 and 6.
10. In the Theory of Constraints, throughput is
a. Sales less direct materials costs.
b. Sales less bottleneck costs.
c. Sales less variable manufacturing costs.
d. Sales less operating expenses.
e. Sales less contribution margin.
11. Which of the accounting systems below tends to cause the greatest behavioral bias towards creating excess resources within a company?
a. throughput costing.
b. absorption costing.
c. direct costing.
d. job order costing.
e. process costing.
12. Which of the following production control systems is more appropriate in an environment where jobs are produced to customers’ specifications?
a. Activity based costing systems.
b. Throughput costing systems.
c. JIT kanban systems.
d. OPT scheduling systems.
e. Push systems
The Slat Company produces Slat wall. The budgeted manufacturing costs for the product are indicated below.
|Fixed Overhead ($120,000/20,000)||6|
There are no beginning inventories and the actual costs of production are equal to budgeted costs.
During the period, the Company:
Purchased $160,000 worth of direct materials.
Produced 20,000 units incurring $240,000 in conversion costs including $40,000 direct labor, $80,000 variable overhead and $120,000 fixed overhead.
Sold 18,000 units of slat wall for $40 per unit receiving total revenue of $720,000.
Incurred selling and administrative expenses of $30,000 variable and $50,000 fixed.
Determined that the ending inventory included 2,000 finished units, zero equivalent units in process and zero unused direct materials.
1. Slat Company’s before tax net income based on absorption costing is
a. $240,000 b. $252,000 c. $256,000 d. $268,000 e. $280,000
2. Slat Company’s before tax net income based on direct costing is
a. $240,000 b. $252,000 c. $256,000 d. $268,000 e. $280,000
3. Slat Company’s before tax net income based on throughput costing is
a. $240,000 b. $252,000 c. $256,000 d. $268,000 e. $280,000