Chapter Nineteen: Job Costing and Modern Cost Management Systems
Purchase the 2015 Edition of the Managerial Accounting Textbook (Chapters 17 through 24 including problem sets) for $74.95 here.
Purchase the 2015 Edition of the Managerial Accounting Textbook PDF Download (Chapters 17 through 24 including problem sets) for $29.95 here.
Purchase the Managerial Accounting Workbook 2015 Edition (Chapters 17 through 24) for $34.95 here.
Purchase the PDF download of the Workbook for $29.95 here:
Purchase the Managerial Accounting Solutions Manual 2015 Edition (Chapters 17 through 24) for $39.95 here.
Purchase the PDF download of the Solutions Manual for $29.95 here:
Chapter 17 introduced product costing, the schedule of cost of goods manufactured, and the basic cost flow of a manufacturer. In that preliminary presentation, most cost data (e.g., ending work in process inventory, etc.) were “given.” Chapter 18 showed how cost data are used in making important business decisions. How does one determine the cost data for products and services that are the end result of productive processes? The answer to this question is complex.
Multiple persons, parts, and processes may be needed to bring about a deliverable output. Think about an automobile manufacturer; what is the dollar amount of “cost” for the hundreds of cars that are in various stages of completion at the end of a month? This chapter, and the next, will provide a sense of how business information systems are used to generate these important cost data. This chapter focuses on the job costing technique, and the next chapter will look more closely at process costing and other options.
Job costing (also called job order costing) is best suited to those situations where goods and services are produced upon receipt of a customer order, according to customer specifications, or in separate batches. For example, a ship builder would likely accumulate costs for each ship produced. An aircraft manufacturer would find this method logical. Construction companies and home builders would naturally gravitate to a job costing approach. Each job is somewhat unique. Materials and labor can be readily traced to each job, and the cost assignment logically follows.
Jack Castle owns an electrical contracting company, Castle Electric. Jack provides a variety of products and services to clientele. Jack has four employees, a rented shop, a broad inventory of parts, and a fleet of five service trucks. On a typical day, Jack will arrive at the shop early and line out the day’s work assignments. Around 8:00 a.m., his electricians arrive, and he gives them their assignments, as well as the necessary parts and equipment they will need. They are then dispatched to the various job sites.
One of Jack’s electricians is Donnie Odom. On July 14, Donnie arrived at the shop at 8:00 a.m. He first spent 30 minutes getting his assignments and loading a service truck with necessary items to complete the day’s work. His three tasks for the day included:
- Job A: Cleaning and reconnecting the electrical connections and replacing a flood light atop a billboard (materials required include one lamp at $150).
- Job B: Replacing the breakers on an old electrical distribution panel at an office building (materials required include 20 breakers at $20 each).
- Job C: Pulling wire for a new residence under construction (materials required include 500 feet of wire at $0.14 per foot).
Donnie successfully completed all three tasks. He spent one hour on the billboard, two hours on the electrical panel, and three hours on the residential installation. The other two hours of his 8-hour day were spent on indirect job administration and travel. During the day, Donnie also used a roll of electrical tape ($3) and a box of wire nuts (60 nuts at $0.05 each). Donnie is paid $18 per hour. Donnie drove a truck and he used a variety of tools, ladders, and other specialized equipment. Jack is paid $25 per hour, and he does not work on any specific job. Instead, his time is spent doing inspections, getting permits, managing inventory, and other tasks.
How much did it “cost” to change the light on the billboard? Obviously, the job cost included the direct costs of the job; specifically, Donnie’s direct labor time (one hour) and the direct material (one lamp at $150). But, the job could not have gotten done without the shop, equipment, trucks, indirect labor time, tape, wire nuts, and so forth. These latter items constitute the indirect costs, or overhead. How are these costs assigned to a specific job?
A logical starting point is to specifically track labor cost. Donnie, and the other electricians, fill out a time report documenting time spent on each job, as well as the time spent on other tasks:
Jack keeps detailed records of the material released to each job. When Donnie gathered up the light bulbs, breakers, wire, tape, and wire nuts on the morning of the 14th, some system needed to be in place to “check out” this material. The document that is used for this process is called a “materials request” or materials requisition form. This form will show what material is leaving the available raw materials stock and being put into production. Sometimes a separate form is prepared for each item, and sometimes a running list similar to the following is used:
This form provides essential documentation to track inventory. It also reveals that the “direct material” for the billboard task (Job A) was $150 (the light bulb). The wire nuts and tape that might have been used on the billboard will be dealt with as overhead, which is discussed later.
Although the illustrated form lists the material cost, that will not always be the case. Sometimes, a business will not be particularly interested in letting employees see cost information, or cost information may not be readily available. In either case, the form will instead include a part or serial number. A subsequent clerical task will be to identify the cost of the particular parts that were put into production.
Jack would have a huge task at hand if he tried to daily trace all items of overhead. For instance:
- How hard would it be to track the “indirect material”? How many wire nuts were used on the billboard? How many inches of electrical tape were used? What was the cost of these items?
- What about indirect labor? Should the cost of Donnie’s two hours of travel and administrative time be spread over the three jobs equally, pro-rata based on hours, or on some other basis? What about Jack’s time? He is supervising four electricians. Should the cost of his time be allocated 1/4 to each, or based on some other formula?
- One must also consider the cost of rent, trucks, and so forth. Donnie needed a ladder to scale the billboard. How much is the “ladder cost” for one job?
Tracking overhead is tricky. One way this is done is by using a predetermined overhead rate. Assume Jack sat down at the beginning of the year with his accountant. Together they carefully considered all of the production overhead that was anticipated during the year. This included the cost of Jack’s time, rent, the cost of vehicles, insurance, taxes, utilities, indirect labor, indirect materials, depreciation of long-lived assets, and so forth.
The expected total came to about $150,000. Jack figures that his four electricians will work a total of about 7,500 direct labor hours during the year. By comparing these two numbers ($150,000 and 7,500 hours), it is now possible to “model” that overhead is $20 per direct labor hour. A logical overhead application rate is thus determined.
Two things should be made clear. First, overhead application is arbitrary. Jack decided to apply overhead based on direct labor hours; this is a common choice, but not the only choice. Some other systematic and rational approach could have been developed. Ordinarily, one would try to establish some correlation between the application base and overall cost incurrence. For instance, feet of wire used (instead of direct labor hours) could have been selected as the application base. But, feet of wire used would be hard to defend since two of Donnie’s three jobs did not use any wire and would not be assigned any of the business overhead.
The point is that some logical method needs to be used to attach overhead costs to output, but no single choice is absolute. Cost allocation necessarily involves some degree of arbitrary methodology; this is neither bad nor good, it is just reality. In some ways, costing is more of an “art” than “science,” despite its outward appearance of mathematical precision.
Second, expect differences between the actual overhead and the amount applied to production. For instance, Jack will likely discover that actual overhead is more or less than $150,000. Jack will also find that his electricians will probably work more or less than the anticipated 7,500 hours. Accounting for the difference between the amount of overhead applied to production (i.e., direct labor hours X $20 per hour rate) and the actual amount spent will be shown later in the chapter.
Note the form reference to the source documents (e.g., “DTS.07.14.X5.DO” to indicate “daily time sheet of July 14, 20X5, for Donnie Odom”). In similar fashion, Donnie’s materials requisition form was used as the source document for compiling the direct material information for each job. Overhead was applied directly to the job cost sheets based upon the predetermined overhead application scheme of $20 per direct labor hour.
Jack could maintain some or all of his job costing system manually. Or, he could use an electronic spreadsheet to prepare reports similar to those just illustrated. However, the electronic database is a more powerful tool. A number of commercial packages are available.
Generalizing, data are entered via a user-friendly input form that includes a number of predetermined “slots” for entering desired information. For instance, below is a data entry form for entering Donnie’s time and material for the 14th:
The benefit of the database approach is that information is only entered once; it need not be transferred to other forms. The computer files can be queried in many ways and generate more than a simple job cost report.
For instance, Jack could use the customized reports feature to find all jobs on which billboard light bulbs were used during the past 18 months, or determine the total direct labor hours of any employee for a selected time interval, or identify all jobs performed for a selected client, and so forth. Such databases provide a powerful management tool.
Thus far, the illustration has focused only on Donnie’s activities. He had relatively simple assignments on July 14 and was able to complete three separate jobs by himself. But, remember that Jack has three other electricians and many other jobs. Some of these jobs may require multiple employees and extend over several days. One such job was the new home of Aba Obekie. This job took two electricians (Andy Axon and Bev Bentson) three full days to complete. The resulting job cost sheet appeared as follows:
Thus far, a basic illustration has been used. What this fails to consider are factors such as these:
- The sophistication of the information systems that are used to track job costs.
- The debits and credits that are needed to track the accumulation and application of costs within a company’s general ledger system.
- The ultimate disposition of the difference between applied and actual overhead.
Each of these issues will be dealt with in following sections of this chapter.
Search the internet for “factory automation,” “bar code scanners,” or “RFID,” and discover continuing advances in manufacturing technology. Robots and machines have resulted in quantum leaps in productivity and quality. A similar revolution has occurred in the deployment of job costing technology.
Purchasing a computer requires one to choose components relating to memory, hard drives, and so on. Each unique computer represents a unique job, and will have a unique cost. How can cost data be efficiently captured? If one were to open up the housing on a computer, one would quickly note that many of the expensive parts within have serial numbers, barcodes, or other unique identifiers. These IDs were likely mechanically scanned into a database to match them with the serial number of the finished computer unit. As a result, a computer manufacturer can tell exactly which memory chips, hard drives, etc. are installed on a specific computer. This is helpful for warranty processing, product recalls, and other inventory management issues. But, that same data can also be used to produce a listing of direct material cost for each unit produced.
Technology is also used to track and log time to specific jobs via various “login clocks.” Note that the information being tracked is essentially the same as what Donnie was providing to Jack via the daily time sheet, but with added efficiency, accuracy, and control. In addition to monitoring job cost, a manager must also safeguard corporate resources. Here, technology can play a key role.
Newer systems require biometric validation (like fingerprint IDs) of employees working on a project. These tools are used to make sure that employees who claim time working on a job are in fact working on the job. Such systems can also be used to limit access to inventory. Rather than allowing free access to an inventory storage area, or providing a human “guard,” technology can control who comes and goes, and what they take with them when they leave.
Some products are produced on an assembly line. A designated amount of time is available per task, as the line keeps moving production along at a constant rate. An employee might perform the same operation on 50 or more units per hour. It would take more time to measure and record the labor for each job than it takes to perform the task itself.
In this type of environment, cost is usually assigned to jobs based on the average or standard time for each activity. In essence, if an employee is expected to work on 60 units per hour, one minute of direct labor time/cost would be assigned to each unit for the employee’s specific task. A subsequent chapter will show how deviations from standards are measured and reported.
The application of overhead to jobs is mostly an exercise in algebra. Jack applied overhead at the rate of $20 for each hour of direct labor. A similar exercise is used to apply overhead in the automated factory environment. Some predetermined scheme is used to apply overhead to production. In a highly mechanized environment, one must give careful thought to the cost driver.
The cost driver is the factor that is viewed as causing costs to be incurred within an organization. It is best viewed only in an abstract context, as there are too many individual variables for any single factor to fully explain all cost incurrence. Labor hours may not be the most significant cost driver in a mechanized setting. Machine hours, number of bar code scans, fuel consumption, or number of assembly steps could each provide a potential basis for allocating overhead. This choice must be logical, as it will govern the allocation of total overhead costs to individual products.
Product pricing, CVP analysis, inventory values, and so forth are dependent upon costing information driven by overhead allocation. This underscores the importance of correct methodology in identifying cost drivers. To do otherwise could result in serious costing errors.
Suppose a computer manufacturer allocated overhead based on the amount of installed memory. As a result, a machine with 2 GB of memory would absorb twice as much overhead as a machine with 1 GB. This is probably not a good idea; there is little difference in the production process needed to manufacture the 2 machines (save and except the difference in direct material cost for memory chips). The faulty overhead allocation could cause management to conclude that the 2 GB machines were too costly to produce, while the 1 GB machines seem a relative bargain.
Management accountants have long studied the overhead allocation problem. With so much at stake, quite a lot of thought has been put into ways to improve this effort. The next chapter will present activity-based costing (ABC). ABC seeks to overcome some of the issues just described by dividing production into its component processes (“activities”) and more closely associating overhead with each unique process. But, ABC has its own limitations, so do not be too quick to dismiss the merits of the overhead allocation approach introduced in this chapter.
Thus far, the illustrations of job costing have focused on methods to accumulate job cost information. In a sophisticated electronic environment, that information can be seamlessly transferred to a company’s general ledger system.
In the alternative, one may still need to transcribe the cost flow information via a series of entries. Either way, it is imperative to not only understand how job cost data are measured, but also how they impact a company’s general ledger and financial statements.
Begin by considering how a job cost travels through the accounting system by focusing on direct materials. Below is an illustration for a company that buys pipe from a steel mill. The manufacturing process entails a specialized heat treating, machining, and polishing process that converts the pipe to gears. The flow of direct materials occurs in the following four steps:
For purposes of this illustration, assume the raw material in the first picture cost $10,000. This expenditure must be captured in inventory and eventually transferred to cost of goods sold when the product is delivered to an end customer. At the time it is acquired, the Raw Materials Inventory needs to be increased by $10,000, as shown in the following T-account.
The second step will result in a reduction in the Raw Materials Inventory and a corresponding increase in the Work in Process Inventory. Upon completion, that cost is transferred from Work in Process Inventory to Finished Goods Inventory. When the product is sold, the cost moves out of Finished Goods Inventory. At this point, only the cost flow of direct materials is illustrated; direct labor and overhead costs will be shown later.
Carefully review the above set of entries, and focus on the fact that $10,000 of cost was incurred when the raw material was purchased in Step 1. And, that cost eventually became a cost of goods sold at the end of the process when the goods were delivered to the customer in Step 4 (remember, only the direct material is being shown here; labor and overhead costs are yet to be considered).
Concurrent with recording the fourth entry, another entry would be made to record the sale (debit Accounts Receivable and credit Sales). The difference between Sales and Cost of Sales would be the gross profit. These entries assume a perpetual inventory system; the same result could be achieved with a periodic system like that illustrated earlier in the book.
Next focus exclusively on the direct labor cost, ignoring materials and overhead. Direct laborers were required in the production process. This suggests the introduction of direct labor into the costing equation. Like the cost of raw materials, the salaries payable for direct labor are added to Work in Process Inventory (at “stage 2” of the diagram). The following entries assume that production required 200 hours of direct labor at $15 per hour:
Notice that the accounts used in these entries are identical to those for direct material, except that the credit in the first entry is to Salaries Payable. This reflects that the cost is attributable to an obligation to pay employees for their time.
Take one more look at the “work in process” picture, and think about the factory overhead that is being “used” to process the raw material. What components can be identified or contemplated? Likely, the list will include utilities costs, insurance, factory maintenance, depreciation, supplies, and similar items. These costs must be attached to the products. The method of attachment is by applying overhead based on a predetermined estimated rate. Assume the factory applies overhead at the rate of $25 per direct labor hour. The following entries are needed to apply overhead:
Notice that an account entitled “Factory Overhead” was uniquely credited in the first of these entries. This account can be confusing. For the moment, accept this truncated explanation: The credit to Factory Overhead is the allocation tool used to pass along the actual overhead costs to jobs in progress. The actual overhead costs are captured via debits to this account through a separate process described later.
The preceding information can be combined and summarized as follows:
The general journal effects are captured by the following entries:
How a job’s cost appears on the financial statements depends on its condition at the financial statement date. Considering the previous illustration:
- If the raw material had not yet started into production, its $10,000 cost would appear in the raw materials inventory category on the balance sheet:
- If the material was in production but not complete, the total cost in the Work in Process account as of the balance sheet date would be aggregated and presented as work in process inventory on the balance sheet. For example, assume all of the raw material was in process, but only half of the necessary labor tasks had been performed; in this case, the Work in Process Inventory account would include $14,000 ($10,000 direct material + $1,500 labor + $2,500 applied overhead):
- If the gears were completed but unsold, the finished goods inventory would be carried at $18,000 on the balance sheet:
- If the gears were sold for $25,000, the income statement would include sales ($25,000) and cost of goods sold ($18,000), netting to the $7,000 gross profit:
Recall that a company’s general ledger will reveal the total accounts receivable, total accounts payable, total equipment, etc. But, there is also need to know subsidiary details about each of these accounts. In other words, one must be able to identify the specific customers who owe money, how much is due to each vendor, how much depreciation to record for each asset, and so forth. The same is true for the Work in Process account.
While it is imperative to know the total dollar value of all jobs, a company must also be able to pinpoint the amount attributable to each job. This is accomplished via an account numbering scheme where each job is given a unique number. This enables ease of data mining. The chart of accounts typically includes a number where the leading digits indicate the control account, and the trailing digits indicate the subsidiary account. For work in process, this numbering could be as illustrated at right.
While the exact mechanics of maintaining subsidiary account balance information can vary, what is important is that one could inspect the general ledger and financial statements, and find $290,000 in work in process.
The subsidiary account information should be sufficient to allow one to find that Job A represents $35,000 of the total, Job B represents $25,000, and so forth.
Companies engaged in international commerce often establish separate operating units around the globe. For instance, a company may establish a manufacturing facility in a country with lower wages, taxes, and costs of production. This trend has introduced a myriad of complex costing issues, which generally fall under the heading of transfer pricing.
The heart of the issue is how to assess costs and set prices for goods produced in one venue and transferred to an affiliate in another venue. The governments of each country have a keen interest in taxing activities within their domain (whether it be by value added taxes, income taxes, tariff systems, customs duties, etc.). And, companies will envision an opportunity to shift profits from high-tax jurisdictions to low-tax jurisdictions by shuffling costs and prices between entities. This is a fertile area of tax dispute, and one that keeps many managerial accountants quite busy. Mostly, the applicable rules attempt to require the use of fair and equitable job costing, and require that transfers be based on “arm’s length” transaction pricing. But, the details of implementation are problematic. A recent internet search turned up over five million hits for “transfer pricing rules.”
Transfer pricing issues are not limited to global companies. Issues can arise when products are shipped between affiliated companies in different states or provinces. Also, affiliated companies may have divisional profit incentives, causing managers working for the same corporate parent to debate the costs assigned to their respective units. Such consolidated enterprises often have established rules about pricing of intercompany transactions.
As previously shown, overhead is applied based on a predetermined formula, after careful analysis of the appropriate cost drivers for this allocation. An account called “Factory Overhead” is credited to reflect this overhead application to work in process. But, what is the source of the debits to Factory Overhead?
As the overhead costs are actually incurred, the Factory Overhead account is debited, and logically offsetting accounts are credited. The table below provides representative examples.
The indirect labor would relate to the cost of factory staff not directly involved in production. This can include break time of line workers, shop managers, maintenance, guards, and so forth. The indirect materials relates to supplies and components that are not a significant cost item. Importantly, selling and administrative costs not related to production (e.g., advertising, salaries for non-production related staff, sales commissions, rent of the corporate offices, etc.) are separately expensed, and are not part of factory overhead. A typical entry to record factory overhead costs would be as follows:
To recap, the Factory Overhead account is not a typical account. It does not represent an asset, liability, expense, or any other element of financial statements. Instead, it is a “suspense” or “clearing” account. Amounts go into the account and are then transferred out to other accounts. In this case, actual overhead goes in, and applied overhead goes out.
Since the Factory Overhead account is debited for actual overhead incurred and credited for allocated (applied) overhead, the general ledger account would appear as follows (the job costs are newly assumed for this illustration):
The next graphic provides a visual representation of the cost flow associated with the Factory Overhead account. In this case, the applied overhead equaled the actual overhead, leaving a zero balance. This means that the predetermined allocation rate was exactly what was incurred during the period. More often than not, this level of perfection will not result.
A more likely outcome is that the applied overhead will not equal the actual overhead. The following graphic shows a case where $100,000 of overhead was actually incurred, but only $90,000 was applied.
This last situation is called underapplied overhead. It is said to be an “unfavorable” outcome, because not enough jobs were produced to absorb all of the overhead incurred. This might result from below normal levels of output or overspending. In any event, the fact remains that more was spent than allocated. Because the Factory Overhead account is just a clearing account (not a financial statement account), the remaining balance must be transferred out. Several options are available for disposing of this amount, but one approach is to remove (credit) the underapplied amount and charge (debit) Cost of Goods Sold:
The preceding entry has the effect of reducing income for the excessive overhead expenditures. Only $90,000 was assigned directly to inventory and the remainder was charged to cost of goods sold.
If the applied overhead exceeds the actual amount incurred, overhead is said to be overapplied. This is usually viewed as a favorable outcome, because less has been spent than anticipated for the level of achieved production.
The next journal entry shows the reduction of cost of goods sold to offset the amount of overapplied overhead:
Always keep in mind that the goal is to “zero out” the Factory Overhead account and measure the actual cost incurred. In this last example, $100,000 was actually spent and accounted for: $110,000 charged to specific jobs and $10,000 offset as a reduction in cost of goods sold.
These illustrations of the disposition of under- and overapplied overhead are typical, but not the only solution. A more theoretically correct approach would be to reduce cost of goods sold, work in process inventory, and finished goods inventory on a pro-rata basis. However, this approach is cumbersome and occasionally runs afoul of specific accounting rules discussed next.
Although managerial accounting information is generally viewed as for internal use only, be mindful that many manufacturing companies do prepare external financial statements. And, generally accepted accounting principles dictate the form and content of those reports.
For example, generally accepted accounting principles require that underapplied overhead relating to idle facilities, wasted material, the allocation of fixed production overhead, and so forth, be charged to current period income by means similar to those just illustrated.
The last hundred-plus years have seen a primarily agriculture-based economy give way to industrialization. This revolution took root and continues to sweep around the globe. Following the growth in manufacturing production has been an even greater proliferation of support and service roles. Perhaps as few as 10% of workforce members are now actively producing a tangible end product. As a result, it has become very important to measure costs associated with services provided to others.
Most employees in the private sector are engaged in nonmanufacturing activities like accounting, sales, computing, and administration. New businesses have developed in the areas of law, healthcare, food services, electronic information delivery, transportation, entertainment, and others. The not-for-profit sector is increasing; consider the size and scope of educational institutions, hospitals, foundations, and so forth.
And, not to be forgotten, is the size and scope of governmental entities. Cities provide services like municipal infrastructure, fire, police, water utilities, and code enforcement. State and provincial governments may provide for the educational system, highways, and prisons. At the federal level, governments may provide military, welfare, transportation, and countless other services. It is no wonder that most people work in a nonmanufacturing role.
The job costing model presented in this chapter is generally suggestive of the idea that a “job” can be identified as some tangible product. But, that is not necessarily the case. This chapter opened with an illustration for Castle Electric. Thinking deeper about that example, realize that most of what Jack Castle provided to his customers was a “service.” But, the utilization of job costing methodologies was still highly relevant.
The cost of services, whether provided in the private sector, not-for-profit, or governmental arenas, must be determined with some reasonable degree of accuracy. The growth, indeed dominance, of these sectors of the economy underscores the need to extend costing methods beyond the traditional manufacturing setting.
The concept of a “job” gives way to more abstract connotations: “client,” “surgical procedure,” “seat mile,” “student credit hour,” “fire call,” or other measure of output. Clearly, direct materials become a less significant part of the overall picture. But, overhead can take on heightened levels of importance.
Consider a costly hospital visit. The itemized billing that follows usually includes some shocking components (e.g., $5 for an aspirin). These prices cannot be justified based on direct material cost alone. Clearly, the hospital has tremendous and costly overhead. In addition, one doesn’t just take an aspirin in the hospital. The pill must be administered, documented, and billed; efforts which consume expensive labor time. If costing methods are not employed correctly, the organization may find that it has underestimated its costs of services. This can lead to financial failure. On the other hand, many will question the cost drivers and methods of allocations that are used in service type activities.
For instance, a city may determine that the full cost of a fire department is several hundred thousand dollars per residential house fire. This type of job costing could lead one to conclude that a fire department is not cost effective. The problem with this approach is that it ignores that one fire would quickly spread to an entire city without a suppression action by the fire department. And, firefighters save countless lives for which there can be no rational economic measure. So, what is the actual “job” and how are costs to be assigned to that “job?” This measurement issue is a pervasive and challenging problem within the service sector, requiring management accounting expertise.
A root of the problem is that traditional job costing allocates overhead based on the expected output. In contrast, it may sometimes make more sense to charge individual jobs based on full capacity utilization, provided a plan is in place to maintain the financial viability of the organization. Capacity utilization refers to the degree to which an organization’s output capabilities are being deployed or utilized at a given point in time.
To illustrate this concept, assume that a local ambulance service was capable of providing 30,000 calls per year, but only expected to make 10,000 actual calls. If the overhead of the ambulance company was $30,000,000, the overhead allocation would be either $3,000 per call (based on estimated activity) or $1,000 per call (based on full capacity utilization). If the entity set customer charges based on the $3,000 amount, it might soon find that it generates fewer calls, because people opt not to utilize the service. In essence, a handful of actual patients are put in the position of paying for the ambulance service that is available to everyone. A more logical approach might be to cost the service based on the $1,000 figure, and then recover the additional cost by some form of tax or fee that falls on all potential patrons of the ambulance service (whether they use it or not during a given time period).
These capacity utilization and costing considerations are in play for all organizations, but they seem to present a particularly vexing problem for the service sector. As a general rule, when overhead is allocated based on full capacity rather than expected output, one can expect considerable underapplied overhead.
Managers need to be keenly aware of this as they plot their ultimate financial strategies. Great care must be taken to avoid dysfunctional decisions based on erroneously high or low costing. There are many theories and methods, but none of them replaces a savvy decision made by a well-informed manager who understands the nuances of job costing.
Accountants have a reputation for being focused on cost control. Perhaps this reputation can be traced back to the 1843 book by Charles Dickens entitled A Christmas Carol. In that tale, Ebenezer Scrooge is a penny-pinching miser who cares nothing for the people around him. His sole purpose is making money, and his trusted but suffering accountant is Bob Cratchit who painstakingly tracks every penny.
Today’s accountants still focus on measuring and controlling the costs of a business. And, this pursuit sometimes earns them the scorn of their associates who may be more interested in engineering, product development, marketing, and other facets of the business. The accountants, and their numbers, are sometimes seen as profit obsessed and, therefore, limiting the potential to achieve other objectives.
But, modern managerial accounting techniques are causing a shift in this reputation. Technologically advanced information systems mean less time needs to be spent on data capture, and more time can be devoted to analyzing data and making sound business decisions.
One result of the rise in global competition has been a cross-pollination of best business practices. Interestingly, many profitable businesses come out of environments where profit is not the primary motivation. What has been learned from this is that business success can be achieved by a fixation on issues such as quality, employee involvement, customer satisfaction, and the like; profit is the result, not the objective.
Kaizen is a Japanese term used to describe a blitz-like approach to study processes and install efficiency within an organization. This approach relies on frontline employee input for “quick fix” suggestions relating to business processes. Essentially, focus sessions are conducted in search of the obvious areas of operational improvement. These sessions are usually “observed” or “moderated” by members of the strategic finance, managerial accounting, and industrial engineering teams. But, these “experts” are supposed to listen and learn, not suggest or lead the discussions.
What is sought are simple and common sense solutions for issues that may not have even been seen as problems for the business. In one setting, for example, a production facility manufactured metal shelving to be used in refrigeration equipment. Essentially, the product required sheet metal to be stamped and shaped in a series of operations. The facility was cramped, and the product flowed down the production lines like this:
The business was not profitable, and was acquired by an entrepreneur who immediately conducted a Kaizen session. The workers pointed out that they were bumping into each other and disrupting the manufacturing activity as they moved the work in process between the two production lines. The simple fix was to reverse the work flow as follows:
This was a simple, and in retrospect obvious, corrective measure. The savings were huge from this and other Kaizen event fixes! The entrepreneur sold the business at a greatly increased price within just a few years after buying it. There are few businesses that cannot benefit by taking time to listen to employees in search of operational suggestions that make sense. The cost and efficiency savings can be enormous. These Kaizen sessions are also useful in helping employees understand business cost control and its importance to the entire business team.
A term popularized in recent years has been lean manufacturing, which is patterned after the Toyota Production System. This descriptive term is indicative of an environment where waste has been trimmed. But, it also entails a focus on response time and continuous improvement. Other benchmarks of lean manufacturing are the reduction of inventory and the pursuit of standardization for as many processes as possible, without compromising responsiveness to customer demand.
The development of a lean manufacturing facility is not a quick fix like Kaizen. Accountants and others will conduct an extensive and in-depth study of each process with the goal of bringing efficiency to the business. Management accountants should also consider the relevancy of the information they provide for decision making in lean environments. Often, consultants and experts are engaged in implementing lean practices; these outsiders can bring a fresh perspective and valuable insight gained by their service to a variety of other businesses.
To illustrate, there was a time when automakers had many options for each car produced, and customers spent considerable time selecting preferred options. This, in turn, complicated the manufacturer’s production and inventory management. In time, they discovered that the manufacturing process, inventory management, and customer buying experience could be improved by bundling options into two or three packages.
The “leaning” process resulted in a more standardized/streamlined production effort, and produced a better customer experience. The point is that making a lean manufacturing operation does not mean simply cutting costs. Lean is doing more with less. It is the result of an intensive effort to streamline and standardize production, while adding customer value!
Inventory management often benefits from studies into the development of a lean manufacturing environment. Maintaining raw materials inventory entails not only a considerable upfront investment, but also the potential for costly damage and obsolescence. Lean companies will attempt to minimize their raw materials inventory.
One method is adopting just in time (JIT) inventory systems. In an ideal application, raw materials are received from suppliers just as they are needed in the production process. This approach requires a complete and reliable logistics system, as any disruption in the flow of materials can bring the whole production process to a devastating stop.
Such systems are usually dependent upon a strong information system that often links the manufacturer directly to the supplier with automated procurement procedures. A Japanese term that is associated with JIT is Kanban, which means some form of signal that a particular inventory is ready for replenishment.
A popular modification of the JIT system is for suppliers to “store” their inventory at the manufacturer’s physical location. This enables the manufacturer to “buy” raw materials directly from the supplier’s stock located within the same physical location. Finally, note that “compatible” businesses are located in close proximity to one another. For example, a beverage bottler’s neighbor is apt to be an aluminum can manufacturer. All of these measures evolve from significant endeavors to develop lean manufacturing processes, and are usually based upon detailed job cost studies.
Total quality management (TQM) is a key driver of customer satisfaction and business success. Globalization increases the level of competition and drive toward higher product quality. This is often achieved by incorporating detailed standards into the management and productive processes. There is now a globally recognized organization, The International Organization for Standardization, that provides standards and guidelines relating to processes that drive the production of quality outputs. Certifications such as “ISO 9000” suggest that a company is able to demonstrate that it has successfully implemented quality management standards. This becomes increasingly important in selecting global trading partners. An important part of TQM is to stress quality by comparing products and processes to other “world-class” firms. This comparative process is commonly known as benchmarking.
Motorola developed a quality-focused management approach that is responsible for billions of dollars in savings. So popular is the approach, that it has been trademarked by Motorola. Those processes are known as Six Sigma, and they are being deployed by many other companies. GE is a fan of the approach, and its website notes: “Six Sigma is a highly disciplined process that helps us focus on developing and delivering near-perfect products and services.”
“Sigma” is a term from statistics. It is a measure of deviation from a norm. In the case of production management, the “norm” is perfection. With Six Sigma, the organization tracks and monitors “defects” in a process. Then, methods are sought to systematically eliminate the opportunity for such defects. The goal is to achieve nearly “zero defects.” Near zero defects reflect a defect rate that is at least six standard deviations from the norm (hence the name “six sigma”). Such a distribution would have only 3.4 defects per million observations. Importantly, the defects relate not only to final products, but also to all business processes, whether they be in manufacturing, record keeping, or whatever.
Six Sigma revolves around the definition, measurement, and analysis of defects. The management accounting group will be heavily involved in this process. It is often the management accounting unit’s responsibility to suggest improvements and provide controls necessary to drive an organization toward the near-zero defect goal. But, how does this result in cost savings? Companies have learned that quality defects are very costly. The costs come about directly in terms of the corrective actions like warranty work, and indirectly through lost customer satisfaction that can adversely impact future sales. Significant savings are realized via the reduction in the cost of poor quality.
This chapter should serve to highlight an important message: The modern managerial accountant is increasingly deploying technology to deal with mundane data capture, thereby freeing resources to study and analyze techniques needed to drive business success. While penny-pinching is an important part of building a financially successful business, it is also true that one can be penny-wise and pound foolish. Thus, the management accountant is not solely focused on cost cutting, but must also be mindful of measuring and instituting controls that drive an efficiently produced product of high quality.