P2 Advanced Management Accounting

Module: 08

Cost Management

1. Cost management

They say that the next best thing to making money is saving money! And

business is no different. In business keeping track of costs and making sure

you are not spending too much money is considered just as important as

making money.

The key factor in managing costs is to assess the value added by

various activities, not simply looking for what costs the company the

most, as an expensive activity may actually be the key factor in a company’s

competitive advantage. It’s not always about cutting costs therefore – it can be

about spending money wisely on activities that truly add value to the

customer and support profit generation.

There are a number of ways costs and value can be assessed, this

information can then be in turn used to make decisions for the business

going forward.

2. Total Quality Management (TQM)

To start this section on Total Quality Management (TQM), let's use the example of a real car manufacturing company, General Motors. Based in

Detroit, USA, GM sold more cars than any other manufacturer globally for

throughout much of the 20th century.

The story of General Motors is infamous in management circles as a

lesson in “what not to do” when it comes to managing a business in a

changing environment. The world changed, and GM did not anticipate this

and change with it. Eventually, this led to GM losing its place as the number 1

car manufacturer globally and losing billions of dollars. In 2009 at the height

of the financial crisis, the US government spent $50 billion bailing out GM after

it went bankrupt. Since the bailout, GM have partially recovered and are now

a profitable company once more, but they are no longer the dominance they

once were.

At its largest, in 1979, General Motors employed over 600,000 people in the

USA and operated 150 assembly plants. Above all else, it was the sheer size

of GM that led to its decline. There were several attempts by the owners of

GM to try and change the philosophy and culture in the organisation and

although these new ways of working were successfully introduced to a few

of its manufacturing plants the new ideas failed to take hold over the entire

company.

A key barrier for implementing change at GM were the workers unions. The

unions at GM were so powerful and had so many members that any attempt to

introduce policies that were perceived as a threat to the work force, such as

training each employee to be able to perform a number of different tasks on the

production line (seen as possible threat to specialist workers by unions), were

effectively shot down by the unions with the threat of strike action.

The rise of Japanese car manufacturers in the 1970s meant GM could not

rest on its laurels. The oil crisis in 1973 led to soaring fuel prices so smaller

and more efficient cars became increasingly popular. This was bad news for

GM whose best-selling cars were large, powerful and less fuel efficient.

GM began to feel the pinch as sales of smaller, affordable and high-quality

cars made by other manufacturers started to overtake the sales of their own

cars. By 1986, GM started to shut down plants and lay off workers. Until this

point in its history, GM had enjoyed steady growth.

Another major factor that General Motors largely failed to address was the

idea of putting quality first. The cars produced by GM were often large and

luxurious but also unreliable and poorly made. U.S. customers started to see

imported Japanese cars of superior quality and reliability so when it came to

choose the make/brand of car customers were going to buy, quality became

the key word.

It was quality that G

M found so difficult to build into its cars. Conversely, Toyota and other

foreign competitors were producing vast numbers of cars at unseen levels

of quality and reliability.

To this day, “the Toyota way” is used across thousands of organisations in an

effort towards high quality and customer satisfaction.

The practices used by Toyota were built around several simple goals. These

were:

Cost reduction

By creating a manufacturing process that was very efficient and created

zero waste, Toyota were able to produce products at minimal cost which

meant it could sell its cars for substantially lower prices than GM whilst

remaining profitable.

Customer focus

Famously, GM dismissed the rising trend of small cars as a “fad” whilst

Toyota capitalised on the fact that oil was becoming increasingly expensive

and its customers would want to buy a car that was cheaper to run. More

recently, the Toyota Prius was the first mass produced hybrid-vehicle

(electricity and petrol powered) and met the needs of environmentally aware

customers that wanted a fuel-efficient car.

Flexibility

Unlike General Motors, where change was historically difficult to implement, Toyota adapted and adopted new processes as part of its continuous

improvement. We'll discuss continuous improvement later on in this section.

Employee participation

At GM, there was a notorious lack of respect amongst employees for both

the management and the customer. This was largely due to a culture of superiority/inferiority amongst managers and employees. Motivation and

productivity suffered as a result and so the cars that came off the

production line were full of problems.

At Toyota, small teams of workers would perform tasks together and were

encouraged to communicate with one another to solve problems. By taking

more individual responsibility, defects were virtually eliminated as the employees were more careful. Under this philosophy managers were less

important and so the traditional promotion-based schemes were

redundant.

For GM employees, this culture of employee participation and team-work

never took hold. This was because managers did not want to relinquish their

power and workers did not want to give up their dream of one day being

promoted to a more important managerial role.

Shorter product life cycles

As discussed under the customer focus heading, manufacturing cars that

were suited to the current economic climate was hugely advantageous to

Toyota. GM were slower to release “modern” cars and instead stuck with

their historically successful trucks and SUVs which became less desirable as

fuel prices increased.

Emphasis on quality

Toyota became the flagship car company in terms of quality and it

achieved this status through its culture of continuous improvement. If an

issue was discovered, the production line would come to a halt and the

problem would be solved before the product reached the end of the

production line; leading to a flawless final product and virtually no

waste/scrap.

On the other hand, the production lines in General Motors' plants were often

full of problems and poor workmanship but the production line would not

stop. Managers were given incentives (bonuses) based on the volume of

production which led to a lack of quality in the final product.

For Toyota, producing a product of high quality was the overriding focus.

The management of quality is known under various names and forms such as ISO 9000, Lean manufacturing and Six Sigma but these are pre-dated by the following topic, TQM which was first taught as an approach for organisations to use in the 1950s.

Total quality management

TQM is the principle of a culture of quality throughout the whole

organisation. Quality is a key strategic focus. Essentially a successful TQM

programme should mean that problems are avoided in the first instance,

rather than solved. This affects inventory levels as less stock needs to be

carried because there is less waste.

TQM has a number of key principles:

Errors and defects should be prevented, the costs of prevention

being less than the costs of correction. The aim is to achieve no

defects.

Continuous improvement. Not setting targets, meeting them and

then settling. Always looking for improvements everywhere and

anywhere.

Customer focus. Always keep the end user in mind, think what they

may be using the product for. For example, a family car may need

tougher material on the back of the front seats to protect the finish

from moody children kicking!

Quality should be a concern of the whole organisation, not just

production.

To achieve this, TQM programmes require full commitment to TQM from

all staff including the managing director and entire management team. This

means motivating and training staff to take up the ethos of quality.

In TQM, a commitment to quality is not only demanded from the work-

force but also from an organisation's suppliers. Internal customer/supplier

relationships where internal customers demand high quality from their

internal suppliers are an essential part of Total Quality Management. Going

back to the example of GM – General Motors had a history of buying out its

suppliers which led to a reduction in quality of the parts put in its cars. An

external supplier would risk losing business if the quality of their product

dipped, but without this risk GM's internal suppliers focussed on low cost

instead of high quality.

Communication is also an essential part of TQM and mechanisms are put in

place to encourage the sharing of ideas. From these new ideas, processes

are redesigned for quality.

TQM and cost management

In the modern business environment, there is a high cost associated with

poor quality. The loss in revenue caused by failures in quality can cost a

significant proportion of the total sales revenue for the average company.

A real example to remember is the 2014 General Motors recall, where a total

of 29 million cars were recalled, after hundreds of fatal crashes were caused

by an issue where the ignition switch turned off the engine of moving cars.

This fault was due to a number of failures in the initial production. In the

months following the recall, GM were fined $35 million for their slow

response in recalling the cars and an estimated $3 billion was wiped from

their shareholder value.

Quality costs can be divided into two categories:

Conformance costs

The costs of preventing, inspecting and improving to avoid future

problems. These can be split into:

• Prevention costs – e.g. repairs to equipment, quality training.

• Appraisal costs – e.g. inspections.

Non-conformance costs

Costs that occur from inadequate quality. These can be split into:

• Internal failure costs – e.g. costs of scrap, corrections + repairs to fix

products.

• External failure costs – e.g. Loss of customer trust and goodwill, fines compensation/replacement costs.

The level of quality desired must always be weighed up against the extra

time and cost involved in achieving that. The extra costs incurred also

need to be considered and weighed against the benefits gained from the

additional accuracy. Accountants may be required to play a role to examine

costs vs. benefits of different levels of quality.

The aim of TQM is to reduce internal failure costs to zero. It's often said

that the costs of internal failure to companies are so great that a TQM

programme can be paid for by the amount saved.

TQM and standard costing

Total Quality Management does not align with standard costing such as

marginal and absorption costing. There are several reasons that standard

costing and TQM do not work together.

Standard costs which are periodically changed (e.g. for each quarterly

budget) are irrelevant in a system of continuous improvement and so

setting these standard costs is less meaningful in a TQM system.

Waste is not an acceptable cost in a TQM system whereas absorption and

marginal costing systems often have an acceptable level of waste in the budget.

Just In Time inventory control is used in TQM instead of the typical inventory

control as used in standard costing in order to avoid build up of inventory and

stock obsolecence.

The focus of standard costing is on the production cost. However, in TQM,

there is an emphasis on quality costs rather than production costs. For

example, in standard costing, we may be interested in finding out how many

units are produced per machine hour, but in a TQM system we would be

more interested in the number of units produced with defects (which can be

related to the “quality cost” of internal failure).

Finally, under TQM, failures are attributable to all departments which

goes against the standard costing concept that individual departments are

responsible for their own failures.

TQM and management information

To take the focus away from output and towards quality, the traditional

information produced in standard costing is not adequate. To make

decisions in a TQM environment managers need additional

financial information such as:

• Cost of downtime

• Cost of job repairs/warranty claims

• Training costs

Non-financial measures are also required as part of TQM and are reported

in quality reports. These focus on quality and include:

• Customer returns and refunds

• Percentage of defects per unit

• Number of customer complaints

• Customer request response time

As you can see, the costs which can be related to quality are both important

and quite complicated!

For a modern organisation to thrive, quality should be a key focus. We've

discussed the cost of failures in quality and how these led to the overall

decline of a once dominant car manufacturer. In fact, as management

accountants, it should be clear to you that, if GM had focussed on the quality

costs instead of production costs, then many of the problems that the

company encountered could have been avoided entirely.

3. Kaizen costing

One element of TQM is not just about higher quality, it’s about continuous

improvement, and that also can mean finding better ways of achieving the

end goal at a lower cost.

Kaizen

The Japanese art of Kaizen refers to philosophy or practices that focus

upon continuous improvement of processes in manufacturing,

engineering, and business management. It extends beyond simply making

the end product or service better by seeking to improve all parts of the

business; this can be anything from supplier relations to improving the work

environment for employees.

Kaizen seeks to create incremental changes regularly, therefore the

business never gets complacent as it is always trying to change and better

itself. Also, by making little and often changes the company mitigates the

chances of having to undergo a revolutionary change down the road.

Kaizen costing

Kaizen costing is a cost management system focused on continuous

improvement of costs. The focus is on obtaining small, incremental cost

reductions during the production phase (i.e. after design is complete).

How Kaizen costing is applied:

Regular, short term costing targets (e.g. monthly) with the aim of

making ongoing cost improvements on a regular basis – unlike

traditional standard costing which will often have yearly cost targets

There is a culture which focuses on continual cost reduction:

o Reviewing and updating processes to minimise costs

o Looking for the lowest cost provider of the right quality of

output

o Identifying the optimum resources (e.g. most efficient

machinery or staff)

o Reducing waste of input materials.

4. Business Process Re-engineering (BPR)

Business processes

A business process is the set of activities that are ordered in a way to

achieve a task or objective in the organisation e.g. the manufacturing

process, ordering process or complaints process.

Business Process Re-engineering (BPR)

Business process re-engineering is the analysis and design of workflows and

processes to fundamentally rethink how organisations operate in order to

dramatically improve customer service, cut operational costs, improve

quality and be competitive in their market.

The aim of BPR is to design the optimum process to achieve the business

objectives and not effected by those currently used in the organisation. For

this reason, upon implementation it can have a significant impact on staff

and the organisational structure, which may need to be changed to fit the

optimum process.

A key stimulus for re-engineering has been the continuing development and

deployment of sophisticated information systems and networks as these

create new opportunities for changing existing processes.

This image illustrates the life cycle of BPR:

Keys to successful BPR

Due to the size and scale of many BPR programmes, many have failed. Using

this experience the following are the keys to successful implementation of

BPR projects:

Organisation wide commitment – including support from senior

management, funding for new IT and structural change and staff buy-in

Skilled BPR team – with the right skills and knowledge, empowered to take

the actions they need to follow through the process in full

Business needs analysis undertaken prior to process design – to

understand current problems or issues and define the objectives of the

programme. This must be consistent with the business strategy and

customer needs

Adequate IT infrastructure –alignment of IT with the over-riding business

strategy and funding for the IT infrastructure and IT support needed to

support the new processes

Effective change management – to ensure staff buy-in and support

Ongoing continuous improvement - to learn post implementation based on

real world experience

BPR and cost management

BPR can be a very expensive exercise often involving significant costs

spent on external consultants and new IT systems. However one aim of the

new systems is that is it dramatically more efficient than the system that

went before it and so achieving long term savings.

Replacing a manual invoicing system with an automated online system, for

example, would be expensive initially, but over the next few years would save significant staff costs. As a result a NPV analysis could be an excellent

way to review whether the long term costs savings are worthwhile given

the initial costs

5. Lean manufacturing

Lean production and management

Born out of competition between Japanese and Western countries; lean

production is essentially the act of cutting all non-value adding parts of

the business from the value chain; or in layman’s terms achieving the

same outcome from less work and cost. A lean production system will

integrate all employees, managers and suppliers together working together

towards the same goal and remove any people, processes and parts that do

not support that goal.

A lean production environment, should also be one where costs are well

managed, and is consistent with the ideas of Kaizan costing, Just In Time

stock management and value engineering.

One element of lead production is the removal of waste. According to the

Toyota Production System there are details seven key areas of waste:

Transport – When an item or machine is unnecessarily moved when this

movement plays no part in production. For example, you build your car

bodies in one room but attach the wheels next door. The time to transport

between buildings adds no value to the product and so should be removed

from the process.

Inventory – When raw materials, finished products or works in progress are

unnecessarily in stock; this should not happen under lean production as

excess or stationary inventory adds no value to the product. Lean production

systems use a Just-In-Time inventory system.

Motion – People or machines being moving more than is/should be required;

for example, you are a mechanic working on a car production line and your

job is to check and correct any default in the engine. However, every default

requires different tools and the tools must be kept in another room, as a result

at lease once an hour you have to make a 2 minute round trip to the next

room. This is an example of motion that is not beneficially to the product and

so is a waste. If this happened just once an hour you would waste an hour

and twenty minutes a week!

Waiting – Any time a product, person or machine is left waiting to complete

their task is not adding value to the product. To return to our car example, any

time a worker completes their task on a car, a new car should be rolling into

their station. If they have to wait for whatever reason that is wasted time, that

employees time adds no value to the end product during that time and so

steps will need to be taken to ensure waiting time is reduced.

Overproduction – When more stock is produced than needed, the excess

stock will need space to occupy, tie up unnecessary capital and risk stock

obsolescence. Our cars, unlike a fine wine, will not appreciate in value by

being stuck in a warehouse and as a result this storage is not adding

anything to the cars production and value, therefore any overproduction

needs to stop.

Over processing – Another perhaps slightly confusing waste, essentially it

means that more quality or extras added to a product do not necessarily mean

consumers will value it more.

For example, if our cars target market only want a cheap little run around yet

we have spent time and money installing the most expensive branded tyres,

in the eyes of our consumers we have not added any value to the car; they will

NOT be willing to pay more for these tyres. Therefore the time and money

these tyres cost over standard non branded ones is a waste as they did not

contribute value to the customer.

Defects – Defects often cost far more than people think; in addition to the

added costs/time needed to repair the product (or scrap if necessary) we

must also include the materials that went into the product, the cost of the

machines/personnel who made it and the cost of the products that would

have been made in its place.

Often the true cost of a defect can be up to 10 times what it appears to

initially have cost, particularly if it happens after the customer has received the

product where not only are their cost implications but reputation implications

also.

Criticisms and limitations of lean production

As with most forms of production, there are several pitfalls to the seeming

ideal notion of lean production.

Many critics of lean production site management’s focus solely on the tools

and methodologies of lean, rather than the philosophy and culture. For

example, if you work on a production line where you are constantly being

hounded for wastes that fall into the seven areas, but you have no idea why

you too would react negatively, and that is why managers need to install a

culture of ‘lean’ within an organisation so that workers are aware of it and

could in fact attempt to contribute to it.

Capacity can often be an issue for companies using ‘lean production’ as they

are often working at close to full capacity (every input utilised – anything less would be a waste), however, by not having a surplus of materials, stock

and personnel the company can be left high and dry if a massive order

comes in out of the blue or there is suddenly a shortage of raw

materials.

In other words, for lean production to work effectively, everything needs to

keep running smoothly, as there is little to no room for any contingencies.

6. Just-In-Time (JIT)

A car manufacturer begins operations at 9am, by 12pm they will have 10

finished cars. At 12pm they will need to put the tyres on the car, but they do

not produce tyres on site or have any in storage. Instead they order them at

11am from a local tyre manufacturer on a one hour delivery. That means that

at 12pm the completed cars will be ready to have the tyres fitted just as the

tyres are arriving. Therefore, production can continue with no interruption,

yet at the same time the company has not had to waste any floor space in

storing the tyres. This is Just – in – Time!

If you are familiar with the phrase 'just in time' then you should be able to

understand this strategy as it does exactly what it says on the tin!

Definition

Just-In-Time, or JIT, is a business and production strategy that seeks to

eliminate excess stock of products or raw materials, producing

reactively to customer demands and not before. This is generally

known as stock less production as nothing is wasted in production. In

short, the Just-in- Time inventory system focus is having “the right material, at

the right time, at the right place, and in the exact amount.”

JIT is not just for materials entering the production process, but also for the

end product as well. The aim is to produce the product just as it is

required by the customer, so that stocks of finished goods are kept to a

minimum. This requires producing to customer order, or accurate

forecasting of customer demand.

JIT purchasing

JIT purchasing relates to purchasing of materials – at the right time at the right

place and in the exact moment needed for production.

A simple example of this would be a car manufacturer that only orders its steel

once it knows exactly how much it will need in that particular production

period, eliminating waste, as the company should in theory be left with no

excess materials.

A company without inventory does not want a supply system problem that

creates a parts shortage. As a result the supplier relationships become

extremely important and thus are worked upon by both parties. This can

have advantages in terms of delivery times (the supplier may set up a

warehouse near to the company’s production facility for instance), costs,

and quality.

Often companies using JIT work with their suppliers so that regular small

deliveries are made avoiding even the smallest levels of inventory to be

held. In our steel example deliveries could end up being made a few times a

week or even a few times a day if necessary so that it is delivered as is

needed for production.

JIT production

JIT is not just for materials entering the production process, but also for the

end product as well. The aim is to produce the product just as it is required by

the customer, so that stocks of finished goods are kept to a minimum.

This requires producing to customer order, or accurate forecasting of customer

demand.

Benefits of JIT

Some benefits of JIT include:

Less obsolescence and wastage of material

Raw materials are kept to a minimum reducing the chance of the stock

becoming obsolete or damaged.

Less obsolete finished goods inventory reducing production costs

As all products under a JIT system are made specifically to order; you have

greatly reduced the chance of your product not being sold. For example, if a

car company makes 100 cars, maybe only 60 will be sold, but if they make

50 after receiving 50 specific orders they won’t have wasted money on the

excess.

Improved supplier relationships

Improved supplier relationships result from the long term agreements often

signed with suppliers. This ensures good quality stock is received reliably. It

can also help when there are problems, e.g. a stock shortage, perhaps

getting preferential treatment compared with other companies.

Lower costs

As a result to leaner and reactive production waste is reduced and quality is

increased, as a result cost may go down under a well integrated JIT system.

Storage costs are also reduced.

Flexibility

A JIT management system allows for far greater flexibility as products and

procedures are standardised, meaning that changes to order quantity and

design can be more easily catered for.

Downsides of JIT

Despite all the benefits and costs savings of a JIT system it is worth noting

that there are negatives that can lead to complications in production and

management. Generally, these downsides revolve around the lack of

internal control over materials. To illustrate this point, a car manufacturer

that needs to get 10 cars over to a dealership by tomorrow, but the supplier

has run out of a key part would mean the order could not be delivered. In

other words, you are stuck; this is the inherent issue with JIT it removes all

the safety nets that come with having some surplus stock left over for

contingencies.

Some costs may also rise, as suppliers may increase prices to assure

delivery of orders, and there are also likely to be more deliveries of a smaller

number of items, increasing delivery costs.

JIT and cost management

You’ll note from the benefits and downsides of JIT from a cost perspective there

are elements which increase costs (more deliveries) and those that reduce

costs (less storage). An accountant in a JIT environment needs to monitor JIT

related costs to weigh up the costs of the system vs the benefits achieved.