1 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, Chapter 11 Operating Decisions

Overview Operations and the value chain Manufacturing v. services Standard costs Capacity utilization and the cost of spare capacity Capacity utilization and product mix under limited capacity Operating decisions & relevant costs The cost of quality and environmental cost management 2 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Operations Operations is the function that produces the goods or services to satisfy demand from customers, including – purchasing, manufacturing, distribution and logistics The value chain activities themselves’ –‘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 (1985) 3 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Value chain 4 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Operations & accounting  What is the cost of spare capacity?  What product/service mix should be produced where there are capacity constraints?  What are the costs that are relevant for operational decisions? 5 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Value chain & accounting Costs should be assigned to the value chain but accounting systems can get in the way of analysing those costs The cost drivers of each value activity should be analysed to enable comparisons with competitor value chains 6 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Manufacturing 7 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Production methods 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 8 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Accounting for production of products Job costing Bill of materials Labour routing Overhead Process costing Bill of materials Conversion costs Types of inventory: Raw materials Work in progress Finished goods (See Chapter 8: Accounting for Inventory) 9 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Accounting for production of services Differences –Intangibility, heterogeneity, simultaneity and perishability of services – no inventory Types of services: –Professional services (consultants, lawyers) –Mass services (transport, retail) –Service shop (banks, hotels) Fitzgerald et al. (1991)  Professional service compared with customised or batch manufacturing; mass service with continuous manufacture; and service shop with a batch-type process Slack et al. (1995) 10 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Standard costs Budget cost for a product or batch Derived from total product or batch cost divided by quantity of finished goods or services produced –Materials, labour & overhead Standard quantities of materials and labour hours multiplied by the current/ anticipated purchase prices for materials and labour rates of pay, plus an allocation of overhead (Chapter 9) –Expressed per unit 11 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Standard cost illustration 12 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Capacity utilization & 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 Activity-based costing cost of resources supplied – cost of resources used = cost of unused capacity Unused capacity  Reduce the supply of resources or  Increasing the quantity of activities Kaplan & Cooper (1998) 13 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cost of spare capacity Cost of resources supplied – cost of resources used = cost of spare capacity 10 $30,000 Cost driver is 2,000 transactions per person (capacity) 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, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Capacity utilization & product mix Capacity as the limiting factor Ranking of product/services –Contribution per unit of limiting factor 15 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Capacity utilization and product mix 16 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Contribution per unit of limiting factor 17 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Optimum capacity utilisation 18 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Throughput accounting Theory of constraints  Bottleneck defines capacity Throughput contribution = sales – cost of materials  Assumes all other costs are fixed Ranking of product/services –Throughput contribution per unit of bottleneck resource 19 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Throughput contribution 20 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

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 may be opportunity costs –the loss of a future cash flow that takes place as a result of making a particular decision 21 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Avoidable costs Relevant costs are avoidable costs. Unavoidable costs are not relevant because, irrespective of what a decision is, unavoidable costs will still be incurred 22 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Decisions where relevant costs may be important Make versus buy: outsourcing decisions Equipment replacement Relevant cost of materials in a contract 23 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Total costs: make v. buy Fixed costs are not relevant 24 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Relevant costs: make v. buy 25 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Equipment replacement Sunk costs and depreciation are not relevant 26 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Relevant cost of materials Material purchased specifically - relevant cost is the purchase price Material purchased specifically - relevant cost is the purchase price Material already in stock and used regularly - relevant cost is the replacement price Material already in stock and used regularly - relevant cost is the replacement price Material already in stock but surplus - relevant cost is the opportunity cost Material already in stock but surplus - relevant cost is the opportunity cost 27 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Relevant cost of materials 28 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison with accounting cost of materials 29 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Quality Management Total Quality Management (TQM) encompasses design, purchasing, operations, distribution, marketing and administration Continuous improvement requires a systematic approach to quality management which focuses on customers, re-engineers business processes and ensures that all employees are committed to quality –ISO9000 Statistical Process Control (SPC) involves comprehensive measurement E.g. Six Sigma EFQM Business Excellence model 30 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cost of quality The difference between the actual costs of production, selling and after-sales service and the costs that would be incurred if there were no failures during production or usage of product/ services The difference between the actual costs of production, selling and after-sales service and the costs that would be incurred if there were no failures during production or usage of product/ services CIMA definition Conformance costs – prevention costs such as quality measurement and quality training, the costs of inspection and testing Non-conformance costs – Cost of waste or rework before the product/service reaches the customer – Warranty claims, discounts and replacement costsafter the product/service is in the hands of the customer – Warranty claims, discounts and replacement costs after the product/service is in the hands of the customer 31 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Environmental cost management Importance of corporate social responsibility – impact of costs that are externalised to the organization Environmental costs –Land, water and air pollution, waste treatment ISO14000 See chapter 7 for CSR reporting in the Annual Report 32 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Environmental cost reporting Prevention costs: to avoid environmental damage (e.g. the cost of equipment to reduce pollution and the training of employees); Measurement costs, to determine the extent of the organization’s environmental impact (including testing, monitoring and external certification); Internal failure costs, where remedial action has to be taken (e.g. cleaning up spillages or leakages, or employee health and safety-related damages); and External failure costs (e.g. penalties incurred for environmental damage). 33 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Key points Using accounting to help make operations decisions Differences between costing for manufacturing and services Standard costs Cost of spare capacity Capacity utilization and product mix under limited capacity: Ranking by contribution per unit of limited capacity & throughput contribution Operating decisions & relevant costs –Make versus buy, equipment replacement, cost of materials Cost of quality and environmental cost management 34 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,