© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 1

CHAPTER 9 Operating Decisions © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 2

Learning Objectives How is the operations function in manufacturing companies different from the operations function in service companies? Why is it important to calculate the cost of unused capacity? How is this information used in decision making? How can a company maximize profitability by altering the product mix and improving bottleneck operations? How does the analysis of relevant costs in operating decisions improve decision making? Why is it important to monitor and control the costs of quality and environmental costs within companies? © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 3

The Operations Function Operations is the function that produces the goods or services to satisfy demand from customers  purchasing, manufacturing, distribution The all-encompassing processes that produce the goods or services which satisfy customer demand Concerned with the conversion process between resources (materials, facilities, equipment, and people) and the products/services that are sold to customers Depends on factors such as quality, efficiency, capacity utilization, and environmental considerations © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 4

Value Chain activities themselves’ Every business is ‘a collection of activities that are performed to design, produce, market, deliver, and support its product … A firm’s value chain and the way it performs individual activities are a reflection of its history, its strategy, its approach to implementing its strategy, and the underlying economics of the activities themselves’ Porter © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 5 Source: Reprinted from Porter, M. E. (1985). Competitive advantage: creating and sustaining superior performance. ©1985, 1998 by M. E. Porter. All rights reserved.

Value Chain Porter separates business activities into primary and support activities Profits and costs should be assigned to the value chain in order to calculate the profitability of each activity in the chain Accounting systems can get in the way of analyzing the costs of each activity in the value chain The cost drivers of each value activity should be analysed to enable comparisons with competitor value chains © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 6

Industry Value Chain © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 7 Strategically managing a company’s industry value chain  Focus not only on creating value with its own activities but also on creating relationships between business partners  Working together to reduce costs and increase efficiencies in the movement of goods and information

Managing Operations: Manufacturing Types of Manufacturing  Custom  Unique, single products  Batch  A quantity of the same goods produced at the same time ( a production run)  Continuous (or process)  Continuous production process of the same, indistinguishable goods © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 8

Managing Operations: Manufacturing © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 9 The Manufacturing Process and Its Relationship to Accounting

Managing Operations: Services Differences between products and services  Intangibility, heterogeneity, simultaneity and perishability Types  Professional services  Mass services (transport, retail)  Service shop (banks, hotels) Fitzgerald et al. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 10

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 11 Accounting for the Cost of Spare Capacity Utilization of capacity is a key performance driver  Accounting traditionally equates the cost of using resources with the cost of supplying resources Unused capacity  Cost of resources supplied – Cost of resources used = Cost of unused capacity

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 12 Cost of Unused Capacity Cost of resources supplied – cost of resources used = cost of unused capacity 10 $30,000 Cost driver is 2,000 transactions per person Capacity 2,000 x 10 = 20,000 transactions Cost of resources supplied 10 x $30,000 = $300,000 Standard cost per transaction is $300,000/20,000 = $15 per transaction  Actual 18,000 transactions  Cost of resources used 18,000 x $15 = $270,000  Cost of unused capacity = 300,000 – 270,000 = $30,000

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 13 Capacity Utilization and Product Mix Scarce resource will limit the number of units of each product or service that the company can produce and therefore sell Product/service mix is the mix of products or services sold by the business, each of which may have a different selling price and cost When demand exceeds capacity, it is necessary to rank the products/services with the highest contribution margin per unit of the limiting factor

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 14 Capacity Utilization and Product Mix

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 15 Contribution per Unit of Limiting Factor

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 16 Optimum Capacity Utilisation

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 17 Theory of Constraints Theory of constraints  Bottleneck defines capacity  Bottleneck resources are those resources that limit the amount of product or service a company can provide  Throughput contribution = sales – direct materials  Assumes all other costs are fixed Ranking of product/services  Throughput contribution per unit of bottleneck resource

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 18 Throughput Contribution

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 19 Operating Decisions: Relevant Costs Relevant costs are those that are relevant to a particular decision. Relevant costs are the future, incremental cash flows that result from a decision Sunk costs are not relevant Relevant costs are avoidable costs. Unavoidable costs are not relevant because, irrespective of what a decision is, unavoidable costs will still be incurred Relevant costs may be opportunity costs  the loss of a future cash flow that takes place as a result of making a particular decision

Relevant Costs Make v. Buy  Purchase cost of component or product  Variable costs of producing the component or product  Fixed costs that are avoidable Equipment Replacement Decisions  Purchase price of new equipment  Trade-in value of old equipment  Change in operating costs per year  Change in income per year © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 20

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 21 Relevant Costs: Make versus Buy

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 22 Equipment replacement

© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 23 Relevant cost of materials

Quality Management and Control Costs of quality four categories: 1. Prevention costs include design, engineering, and training costs incurred to ensure that a product meets specifications. 2. Appraisal costs include inspection costs and testing costs incurred to identify products that do not meet specifications. 3. Internal failure costs are the costs of rework, spoilage, and repairs that occur prior to the product being sent to the customer. 4. External failure costs include the costs of warranties, repairs, legal claims, and customer service after the product has been sent to or bought by the customer. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 24

Quality Management and Control Total quality management (TQM)  Encompasses design, purchasing, operations, distribution, marketing, and administration.  Involves comprehensive measurement systems, often developed from statistical process control  Aims to improve performance and efficiencies by improving quality. Continuous improvement  A systematic approach to quality management that focuses on customers, re-engineers business processes  Ensures that all employees are committed to quality Six Sigma  A measure of standard deviation  Aims to improve quality by removing defects and the causes of defects.  A customer-oriented approach to managing quality, with customer requirements defining quality improvement goals. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 25

Environmental Cost Management Importance of corporate social responsibility Environmental management accounting is concerned with collecting, measuring, and reporting costs about the environmental impact of an organization’s activities 1. Prevention costs 2. Measurement costs 3. Internal failure costs 4. External failure costs © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 26

Conclusions Using accounting to help make operations decisions  Cost of unused capacity  Capacity utilization and product/service mix  Ranking by contribution per unit of limited capacity and throughput contribution  Relevant costs  Cost of quality and environmental cost management © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 9 27