Chapter 7 The Conversion Cycle

Accounting Information Systems, 5th edition James A. Hall

COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license

Objectives for Chapter 7
‡ Elements and procedures of a traditional production process ‡ Data flows and procedures in a traditional cost accounting system ‡ Accounting controls in a traditional environment ‡ Operating features, philosophies, and technologies of a world-class company ‡ Just-in-time systems and the implications of maintaining excessive inventories in the world-class environment ‡ Importance of quality in the world-class environment ‡ Shortcomings of traditional accounting methods in the worldclass environment ‡ Characteristics of a world-class information system

The Continuum of Manufacturing Practices
The Manufacturing Environment
Traditional Firms Transitional Firms World-Class Firms

Progression toward World-Class Status

A World Class Company«
‡ is a company that has achieved high standards and has undergone fundamental changes from traditional forms of organization and management. ‡ continuously pursues improvement in all aspects of its operations, including its manufacturing procedures. ‡ is highly customer oriented.

Achieving World-Class Status
‡ The world-class firm needs new accounting methods and new information systems that:
± ± ± ± show what matters to its customers identify profitable products identify profitable customers identify opportunities for improving operations and products ± encourage the adoption of value-added activities and processes and identify those that do not add value ± efficiently support multiple users with both financial and nonfinancial information

The Conversion Cycle«
‡ transforms input resources, raw materials, labor, and overhead into finished products or services for sale. ‡ consists of two subsystems:
± the production system ± the cost accounting system

Production System
‡ Involves the planning, scheduling, and control of the physical product through the manufacturing process
± determining raw materials requirements ± authorizing the release of raw materials into production ± authorizing work to be conducted in the production process ± directing the movement of work through the various stages of production

Production Methods
‡ Continuous Processing creates a homogeneous product through a continuous series of standard procedures. ‡ Batch Processing produces discrete groups (batches) of products. ‡ Make-to-Order Processing involves the fabrication of discrete products in accordance with customer specifications.

Documents in the Batch Production System
‡ Sales Forecast - expected demand for the finished goods ‡ Production Schedule - production plan and authorization to produce ‡ Bill of Materials (BOM) - specifies the types and quantities of the raw materials and subassemblies used to produce a single finished good unit

Documents in the Batch Production System
‡ Route Sheet - details the production path a particular batch will take in the manufacturing process
± sequence of operations ± time allotted at each station

‡ Work Order - uses the BOM and route sheet to specify the exact materials and production processes for each batch

Documents in the Batch Production System
‡ Move Ticket - records work done in each work center and authorizes the movement of the batch ‡ Materials Requisition - authorizes the inventory warehouse to release raw materials for use in the production process

Production Planning and Control
Sales Forecast

Raw Materials Requirements
Inventory Status Report Engineering Specifications BOM and route sheets
(Purchase Requisitions)

Operations Requirements

Production Scheduling
work orders move tickets materials requisitions open work orders
work centers

job tickets time cards completed move tickets

cost accounting payroll prod. plan. and control

Upon Completion of the Production Process«
Finished Product and Closed Work Order Closed Work Order Finished Goods Warehouse

Inventory Control status report of raw materials and finished goods journal voucher Prod. Plan. and Control General Ledger

EOQ Inventory Model
‡ Objective: minimize total inventory costs while ensuring that adequate inventories exist to meet current demand ‡ Very simple too use, but assumptions are not always valid

± demand is known and constant ± ordering lead time is known and constant ± total cost per year of placing orders decreases as the order quantities increase ± carrying costs of inventory increases as quantity of orders increases ± no quantity discounts

EOQ Inventory Model
Inventory Cycle Daily Demand


Reorder Point
Lead Time

Time (days)

Cost Accounting System
‡ Records the financial effects of the events occurring in the production process ‡ Initiated by the work order ‡ Cost accounting clerk creates a new cost record for the batch and files in WIP file ‡ The records are updated as materials and labor are used

Elements of the Cost Accounting System
Inventory Control
materials requisitions

Work Centers
job tickets completed move tickets

Update WIP accounts DL DM Mfg. OH. Compute Variances

Cost Accounting System
‡ Receipt of last move ticket signals completion of the production process
± clerk removes the cost sheet from WIP file ± prepares a journal voucher to transfer balance to a finished goods inventory account and forwards to the General Ledger department

Summary of Internal Controls

Internal Controls
‡ Transaction authorizations
± work orders reflect a legitimate need based on sales forecast and the finished goods on hand ± move tickets authorized signatures from each work station authorize the movement of the batch through the work centers ± materials requisitions authorize the warehouse to release materials to the work centers

Internal Controls
‡ Segregation of duties
± production planning and control department is separate from the work centers ± inventory control separate from materials storeroom and finished goods warehouse ± cost accounting function accounts for WIP and should be separate from the work centers in the production process

Internal Controls
‡ Supervision
± supervisors in the work centers oversee the usage of raw materials in the production process to ensure that all released materials are used in production and waste is minimized ± employee time cards and job tickets are checked for accuracy

Internal Controls
‡ Access control
± direct access to assets
‡ storerooms, production work centers, and finished goods warehouses ‡ quantities in excess of standard amounts should require approval

± indirect access to assets
‡ materials requisitions, excess materials requisitions, and employee time cards

Internal Controls
‡ Accounting records
± pre-numbered documents ± work orders ± cost sheets ± move tickets ± job tickets ± material requisitions ± WIP and finished goods files

Internal Controls
‡ Independent verification
± cost accounting reconciles material usage (material requisitions) and labor usage (job tickets) with standards
‡ variances are investigated

± GL dept. verifies movement from WIP to FG by reconciling journal vouchers from cost accounting and inventory subsidiary ledgers from inventory control ± internal and external auditors periodically verify the raw materials and FGs inventories through a physical count

Trends in Competitive Advantage

The World-Class Environment and Manufacturing Flexibility
‡ Customers:
± want quality products ± want them quickly ± want variety

‡ Achieving manufacturing flexibility incorporates four operational characteristics:
± ± ± ± physical reorganization of the production facilities automation of the manufacturing process reduction of inventories high product quality

Physical Reorganization of the Production Facilities
‡ Inefficiencies inherent in the layout of traditional plants add handling costs, conversion, time, and excess inventories to the manufacturing process. ‡ Employees tend to feel ownership over their stations, which is contrary to a team concept. ‡ The reorganization is based on flows through cells which shorten the physical distance between the activities, thus reducing setup and processing time, handling costs, and inventories in the flow.

Progression of Automation in the Manufacturing Process


Islands of Technology

Process Simplification (JIT)

Computer Integrated Manufacturing

Progression of Automation toward World-Class Status

Automation of the Manufacturing Process
‡ Traditional:
± consists of many different types of machines which require a lot of setup time ± machines and operators are organized in functional departments ± WIP follows a circuitous route through the different operations

‡ Islands of Technology:
± stand alone islands which employ computer controlled machines that can perform multiple operations with less human involvement ± less set up time needed

Automating Manufacturing

Automating Manufacturing
‡ Process Simplification:
± reduces the complexity of the physical layout ± groups of CNC machines are arranged in cells to produce an entire part from start to finish ± no human involvement in a cell

‡ Computer Integrated Manufacturing (CIM):
± a completely automated environment which employs automated storage and retrieval systems (AS/RS) and robotics

Automating Manufacturing
‡ Robotics:
± use special CNC machines that are useful in performing hazardous, difficult, and monotonous tasks

‡ Computer-Aided Design (CAD):
± increases engineers¶ productivity ± improves accuracy ± allows firms to be more responsive to market demands ± interfaces with CAM and MRPII systems

Automating Manufacturing
‡ Computer Aided Manufacturing (CAM):
± uses computers to control the physical manufacturing process ± provides greater precision, speed, and control than human production processes

‡ Manufacturing Resources Planning (MRP II):
± an extension of materials requirements planning (MRP) ± more than inventory management--it is a system for coordinating the activities of the entire firm

Automating Manufacturing
‡ Enterprise Resource Planning (ERP) Systems:
± huge commercial software packages that support the information needs of the entire organization, not just the manufacturing functions ± automates all business functions along with full financial and managerial reporting capability

‡ Electronic Data Interchange (EDI):
± external communications with its customers and suppliers via Internet or direct connection

Accounting and MRP

The Evils of Inventories
‡ Inventories cost money and «
± represent an investment ± need to be insured and stored ± can become obsolete over time

‡ Inventories may camouflage production problems. ‡ Willingness to maintain inventories can precipitate overproduction.

Reducing Inventories
‡ Just-in time (JIT) manufacturing is a model that fosters inventories reduction and even elimination. It is based on the following assumptions:
± zero defects ± zero setup time ± small lot sizes ± zero inventories ± zero lead times and reliable vendors ± team attitude

Product Quality
‡ Poor quality is expensive via scrap, reworking, scheduling delays, extra inventories to compensate for defective parts, warranty claims, and service. ‡ Product quality is a basis on which world-class manufacturers compete ‡ Product quality can be improved though control point methods such as statistical process control.

What¶s Wrong with Traditional Cost Accounting Information?
‡ ‡ ‡ ‡ Inaccurate cost allocations Time lag in reporting Financial orientation Emphasis on standard costs

Activity Based Costing (ABC)«
‡ is an information system that provides managers with information about activities and cost objects ‡ assumes that activities cause costs and that products (and other cost objects) create a demand for activities ‡ is different from traditional accounting system since ABC has multiple activity drivers, whereas traditional accounting has only one, e.g. machine hours

Allocation of Costs Using ABC
Total Manufacturing Costs

Activity Cost Pools Activity Cost Drivers

Direct Labor Costs Direct Labor Hours

Materials Costs

Machine Costs

Setup Costs

Order Costs

Material Handling Costs Number of Loads

Quality Assurance Costs Inspection Hours

Number of Materials Used

Machine Hours

Setup Hours

Number of Orders Placed

Product Flow

Activity Management
‡ Managers must understand which activities should be performed and how best to perform them.
± Managers should deploy resources to activities that yield maximum benefits. ± Managers should seek to improve those factories most important to their customers.

Activity Management Tasks
‡ ‡ ‡ ‡ ‡ Evaluating manufacturing activities Identifying nonessential activities Identifying cost drivers Comparing activities to benchmarks Establishing links between key activities

World-Class Information Systems
‡ Integrate all functional and technological components: ± basic accounting applications ± ABC ± materials requirements planning ± capacity planning ± inventory control ± bill-of-materials ± master productions schedule ± forecasting ± order entry ± computer-aided design ± computer-aided manufacturing ± EDI communications links

Need for New Performance Measures in the Information Pyramid
Corporate Management Return on Assets Performance Measures for the Resource Management CSF

VP Manufacturing

Days Inventory on Hand Production/ Equipment Investment Production/ Square Feet Plant


nt Le vel s


Plant Manager


Days of Finished Goods Inventory on Hand

Manufacturing Lead Time (days)

Vendor Lead Time (days)


Department Manager

Number of Unplanned Schedule Changes

Machine Downtime

Percent of Scrapped Production

Process Driver

Machine Breakdowns

Spare Parts Availability

Bottlenecks in Upstream Production Processes

Labor Availability

Power Failures

Control Issues in the WCIS
‡ Paperless environment - no traditional audit trail ‡ Automatic transactions - need assurance that: ± orders are placed only when inventory is needed ± orders are placed only with approved vendors ± the quantity of items ordered is correct ± programs matching electronic controls data before initiating payment perform correctly ‡ Networking considerations

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