Chapter VII

The Conversion Cycle

 Conversion Cycle Activities

The conversion cycle spans a range of activities — product design, production planning and
control, and cost accounting. Product design is a collaborative activity and can involve a number
of specialists from different functional areas. Production planning and control involves planning
production by optimizing factors such as customer demand, availability of materials and labor,
capacity constraints, distribution constraints and storage constraints, to mention a few. Planned
manufacturing activities are carried out by processing raw materials though a combination of
machines and humans and creating a finished product. The cost accounting system provides data
useful for evaluating production function, determining product costs and generating information
for inventory valuation for external reporting purposes.

The twin objectives of quality and cost reduction have been a holy grail for manufacturing
organizations. The last few decades have seen a number of methodologies, such as material
requirements planning (MRP), manufacturing resource planning (MRP II), Just in Time (JIT),
Robotics and Six Sigma, which strived to achieve these objectives. The conversion cycle is most
visible in manufacturing organizations; however, the service industry has also benefited from
conversion cycle concepts and theories. The conversion cycle interfaces with different functions
and departments in the organization, such as purchasing, marketing and finance. Initial efforts for
quality and cost management focused on connecting different departments and streamlining
internal operations of organizations.

As organizations succeeded in squeezing costs from internal operations and improved product
quality, their attention turned to activities and entities external to the organization. Suppliers who
supplied raw materials, carriers who moved goods, distribution networks who distributed goods
and customers who fueled demand; all of these external entities came under intense scrutiny. The
field of SCM that comprehensively deals with all these activities was born in the 1970s, but
gained prominence during the 1990s. SCM deals with the entire gamut of sourcing, production
planning and control, and distribution activities to begin with! SCM, a complex field, has many
definitions, many interpretations, many perspectives and no single departmental owner.

The role of accounting in the production cycle has also changed over the years. Initial
involvement of accountants with the conversion cycle was primarily in determination of product
costs and inventory valuation. Changes in the conversion cycle caused changes in cost
accounting systems. Accountants grappled with devising measurements that align incentives of
the production department with corporate objectives. Cost accounting systems evolved to
measure activities (Activity-Based Cost accounting, or ABC), product costs at the design stage
(target costing), quality of products and defect rates, and effects on inventory due to JIT
philosophy, among other things. Financial measurements for determining relative profitability of
products and advising on product mix, product pricing and special decisions such as make or buy
have also seen accountant involvement.

So what are exact changes due to digital accounting in the production area, especially as they
intersect accounting? The Internet has been used as an enabler or facilitator in implementing
accounting processes; however, the Internet has not been used to substantively alter cost
accounting processes in the conversion cycle. However, there has been a number of significant
developments in managing the production function due to Internet-based SCM software. The
focus of cost management and cost accounting has shifted from a single organization to the
entire supply chain. Studying the field of SCM is crucial to understanding digital accounting and
supply chain cost accounting.

First, a conceptual view of SCM is presented, since conversion cycle activities are best studied
under the umbrella of SCM. Second, changes in different areas, such as product design,
production planning and control, and product life cycle management, are investigated, with
particular emphasis on SAP SCM software. Third, changes in cost accounting due to SCM are
explained. Finally, a summary of the chapter rounds off the discussion.

 Supply Chain Management

SCM is not a new concept; in fact, managing supplies and suppliers can be traced back to the
vertical integration undertaken by the automotive industry in the 1930s. Modern origins of SCM
could be traced to the 1960s, when systematic efforts to increase operational efficiency and
inventory reduction were undertaken by corporations. Preliminary efforts were in the areas of
optimizing warehousing and transportation functions. The concepts of SCM crystallized in the
1970s and 1980s, especially under the onslaught of JIT inventory management from Japanese
automotive companies. However, the state of information technology at the time did not provide
implementation capabilities. Theoretical SCM concepts continued to evolve and, by the 1990s,
they embraced the entire supply chain.

ERP systems ushered in an era of integrating internal functions of the organization. Businesses
have become relatively sophisticated in making internal production operations efficient and cost-
effective. SCM was the next step, wherein outside entities were integrated in internal operations
of the company. So what is this supply chain? The supply chain, also known as value chain or
demand chain, refers to the chain of suppliers and their suppliers, manufacturers and
subcontractors, warehouses, transporters and, finally, customers. Basically, the supply chain
encompasses the process of sourcing, procurement, manufacturing and logistics until the product
is delivered to the customer; and may even include the process of discarding or recycling
products.

SCM, as the term implies, involves managing the supply chain. Management of the supply chain
involves a range of complex decisions, strategic to operational. These decisions revolve around
the right product, right price, right cost, right quality, right quantity, right location and right
customer. Historically, supply chain constituents had adversarial relationships. Suppliers wanted
long-term commitments, manufacturers wanted quality supplies at low cost and flexibility,
retailers wanted fewer empty shelves; and even internal functions of the organization had
conflicting objectives. The supply chain operated with inherent contradictions. SCM promises to
replace such contradictions by connecting and harmonizing the supply chain; at least in theory.
Decisions involved in SCM can be categorized as follows — sourcing and procurement,
logistics, production, inventory and customers.

 Sourcing and procurement: The business needs strategies for selecting, identifying and
nurturing suppliers. Quality, location, financial stability, reputation and past performance
are some factors that go into these decisions. Once the supplier is chosen, then its
performance needs to be measured and monitored. The process of managing inventory,
receiving goods, quality control, invoicing and settlement needs to be standardized and
automated. This area overlaps with SRM functionalities seen in the expenditure cycle.

 Logistics: Logistics refers to the process of moving raw materials from the supplier to the
manufacturer, and moving finished goods from the manufacturer to the customer. There
are interim processes of storage, warehousing and selecting carriers to complete
movement of goods. Logistics involves decisions regarding shipment size, modes of
transport, location of distribution centers, order processing costs, optimization of
transport routes and a host of other variables. Logistics models can get very complex very
quickly.

 Production: Strategic production decisions include location of manufacturing facilities;

make-or-buy decisions; capacity of manufacturing facilities; and strategies concerning
the product, such as low-cost or niche products. Operational details are concerned with
production planning and scheduling, quality control, packaging, routing, labor
management and day-to-day management of the plant.
  Inventory: Inventory management choices include JIT or MRP, safety stock, raw material
order policies, finished goods stock level, warehousing locations and WMS, among other
things.

 Customers: Managing customer orders, order entry, invoicing, settlement, customer

service, policies regarding sales returns, resolving customer problems and creating
efficient processes for disposal of returned goods are also considered part of SCM. These
areas obviously overlap with CRM.

The primary objectives of SCM are to maintain the desired service levels and minimize costs
across the supply chain, sometimes referred to as global optimization. An effective SCM also
results in improved profit margins and increased manufacturing throughput. There is nothing
new in these objectives; in fact, almost all tools we have seen so far strive for the same results.
The effective SCM, however, provides visibility — all trading partners can view each other’s
requirements and can collaboratively plan, produce and meet customer expectations.

What parts of business can be considered non-SCM? SCM covers internal operations and
external connections — chain — and most business activities fall under SCM. As such, SCM can
be considered a strategy or management philosophy. The different techniques and philosophies
we have studied so far, such as ERP, CRM or SRM, have overlapping objectives with SCM. The
software suites for ERP, CRM, SRM and SCM all require each other’s functionalities and
databases to operate successfully; the differences are getting blurred.

SCM gained real prominence in the 1990s. Information technology has been the true enabler of
SCM due to data availability and universal communication protocols. The advent of the Internet,
globalization of business, an installed and operational ERP base, and increasing competitive
pressures have accelerated the metamorphosis of SCM from a theoretical concept to real-world
applications. SCM applications are still evolving, and may take many years to mature. The
promise and performance of new technologies has a spotty record, and SCM is no exception.

How is SCM implemented? SCM is an extremely complex process, and its implementation is
akin (or perhaps more complex) to ERP installation. SCM will involve installation of complex
software modules, often on top of an ERP system, changes in corporate policies, redesign of
workflows, changes on the shop floor; and it may extend all the way to preparing trading
partners for changes through investment and education. The implementation of SCM includes
suppliers, wholesalers, distributors, customers, consultants, software vendors, system developers
and system integrators. SCM also needs support from the top leadership, willingness of suppliers
and partners to share information and maintain confidentiality, and sharing of rewards by the
dominant partner. SCM is generally an incremental, not a big-bang, process. The list of required
functionalities for SCM implementation is lengthy, and is reviewed in the context of SAP SCM
software.

 SAP SCM Capabilities

SAP SCM capabilities fall under four categories: supply chain planning, supply chain execution,
supply chain collaboration and supply chain coordination. Due to the fast evolving nature of
SCM and SCM software, there is considerable terminological confusion in these four areas. The
functionalities are not clearly defined, and similar functionalities are marketed under different
names. The following discussion follows SAP software specifications, though SAP white papers
are not entirely consistent, either. Remember the oft-repeated cautionary note: Focus on
functions, not on terms.

SAP SCM functionalities are enabled by SAP SCM tools, such as advanced planner and
optimizer, product life cycle management, enterprise buyer and CRM. In this section, SAP SCM
capabilities are conceptually discussed, and in the next section, specific SAP software modules
are discussed.