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APPENDIX B Management Accounting in the Future Manufacturing Environment 1 The new manufacturing environment will require a major re- thinking of corporations' management accounting systems. Com- puter-integrated manufacturing (CIM) equipment requires exten- sive digital data for command and control of operations. These same data can be user! to measure resource utilization and the quantity and quality of output on a continuous basis. For example, the time each product spends waiting to be processed and actually being processed on each machine is readily available. Also, phys- ical counts on actual output, rework, and scrap can be tracked continuously. Therefore, it becomes possible to compute actual costs on a real-time basis by individual product classes. In contrast, traditional cost measurement systems compute costs and output over fairly Tong periods, typically a month. Be- cause of the time required to collect this information, the monthly cost report is not available until the middle of the subsequent month. Also, the data are aggregated, so monthly variances are difficult to trace to individual products or batches. The new manufacturing technology provides an opportunity to move from cost measurement on a delayed, aggregate basis to performance measurement on a continuous, hourly, or daily basis, by resource category, cost center, and product class. Such new measurements will permit better understanding of product costs and permit more rapid detection of problems and opportunities for learning and improvement of manufacturing processes. 126

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127 The CIM environment will also make cost accounting systems based on direct labor obsolete. Many companies still distribute costs from the factory and from cost centers to products based on direct labor burden rates. Such a system may have been rea- sonable decades ago, when these systems were designed, because direct labor was the most expensive component of total manufac- turing cost. In highly automated environments, however, direct labor is a very small percentage of total costs, 5 percent or even much less. The direct labor that is used is more concerned with set-up and supervision than with actual processing of output. As overhead and indirect costs have escalated and direct labor costs have diminished, the burden rate on direct labor has reached 500 percent or, in highly automated environments, 1,000 to 2,000 per- cent. Clearly, this is a confusing way to trace factory costs to products. More imagination is needed for tracing costs to products, which inevitably will require new and multiple overhead allocation bases. For example, costs associated with materials (purchasing, traffic, receiving, distribution, and storage) can be traced to ma- terials purchases based on material dollars or on quantity, size, or weight of materials, as seems reasonable. Costs associated with acquisition, maintenance, repair, and operation of machines can be traced to products on a machine-hour basis. Costs of produc- tion control and expediting departments can be traced to products based on the number of set-ups. The costs of engineering, quality assurance, and customer support and service should be traced to the products which require or which benefit from the use of these departments. Since materials, equipment, and overhead will be the most important manufacturing costs, it becomes imperative to develop cost accounting systems that will trace these costs to products rather than rely on arbitrary allocations based on direct labor, a diminishing component of manufacturing costs. The present monthly cost accounting reporting cycle, with its allocation of overhead based on direct labor content, exists mainly to distribute manufacturing costs between goods sold and inven- tory so that monthly profit and loss statements can be computed. This financial reporting objective has been the main driver for cost accounting systems. It has created the situation in which cost data

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128 are too late to be very useful in cost control and too aggregated to be helpful in identifying actual costs for product mix and pricing ~ c .eclslons. This financial accounting objective of measuring product costs and profits for periods as short as a month or a quarter, or per- haps even a year, will be undermined by the new manufacturing technology. Most manufacturing costs will become fixed costs product design, equipment and facilities, salaries and wages- which will not vary with the volume of production. Indeed, many of these costs must be incurred before any items are produced; they are sunk costs. The primary variable costs of production will be materials, some energy to operate equipment, and maintenance and repair of machines. This type of cost structure implies very high gross margins; that is, variable costs must be a small fraction of selling prices if the firm is to recover its investment in product and process development, equipment, software development, and prototypes and testing. With this pattern of cash expenditures and cash inflows, in- come measurement over short periods becomes a meaningless ex- ercise since it is wholly dependent on arbitrary assumptions about the amortization of prior-period expenditures to current produc- tion and sales. The more meaningful measurement of income oc- curs over the full span of the product's life cycle. By how much will the net cash revenues (saTes less variable costs and period ex- penses) exceed the investment required to get the product into production? At what rate are current and expected future sales generating cash to recover the cash invested in product and pro- cess development? At the end of the product's life, management will be able to know whether and by how much the product gen- erated cash in excess of that invested in it, but to apportion this income or loss to arbitrarily short periods within this life cycle will not be an interesting or relevant exercise. However, saying that income cannot be measured over short periods does not imply that meaningful short-term performance indicators cannot be devised. Certainly the rate of cash recovery will be an important financial measure, but a variety of nonfi- nancial measures will be equally important. These should include key indicators of manufacturing, marketing, and research and de

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129 velopment success For example, measures of quality, including internal and external failure rates, yields, and rework, can be computed. Measures of production efficiency, such as machine availability, throughput and lead times, average inventory levels, and set-up times, can be calculated. Percentage of delivery times met, whether product development milestones are being achieved, customer satisfaction measures, employee absenteeism, turnover, skill levels, and morale will be much more interesting short-term performance measures than a financial profit figure requiring ar- bitrary allocations of expenditures on past, current, and future product and process developments. Thus, the new manufacturing environment not only will require entirely new cost measurement and management systems, but also will cause managers to aban- don attempts to measure profitability over periods as short as a month, quarter, or even a year. Nonfinancial measures may pro- vide a better indicator of a firm's ability to earn long-term profits than any short-term profit figure managers may attempt to com- pute. Finally, firms will find it necessary to expand their procedures for justifying investment in new process technology. Current pro- cedures tend to emphasize easily quantified savings in labor, ma- terials, or energy. Further, these savings tend to be recognized for arbitrarily truncated periods, sometimes only one or two years. In addition, new equipment is justified on the assumption that the firm will continue to do the same volume of business even if the new investment is not undertaken. None of these assumptions will be valid or helpful when contemplating investment in new process technology, for several reasons. First, while CIM equipment offers significant direct labor sav- ings, it also offers considerable improvements in quality, inventory and floor space reduction, great reductions in throughput and lead times, and flexibility to accommodate product redesigns and new generations of products. To consider only easily measurable labor savings significantly understates the benefits of CIM technology. Second, the benefits from CIM technology will persist over long periods. It is unlikely that the hardware and software invest- ments in CIM technology can be repaid in a couple of years, but the flexibility of this technology ensures that its useful economic

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130 life will be much longer than that of conventional dedicated equip- ment. Therefore, analytic capital authorization procedures must use realistic estimates of the considerable useful economic life of this equipment. Third, firms that do not invest in the new technologies will soon find that they are no longer the low-cost, high-quality pro- ducers and wait experience declining net cash flows. Therefore, the correct way to evaluate new process technology is not to extrap- olate from past and current cash flows, but to find a pattern that predicts the decline in cash flows owing to anticipated adoption of new technology by competitors. ~ summary, the new manufacturing technology will require major modifications in the way Finns measure and manage costs, in their measures of performance both financial and nonfinancial- during short periods, and in the way they justify investments in new technology. Failure to make these modifications will inhibit the ability of firms to be effective and efficient global competitors in the manufacturing environment of the twenty-first century.