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Chapter 7 The Conversion Cycle

Most apparent in manufacturing firms,

  • review of the traditional batch production model

  • examines manufacturing techniques and technologies in world- class companies philosophy of lean manufacturing

o evolved from the Toyota Production System (TPS)


Purpose : to improve efficiency and effectiveness in product design, supplier interaction, factory operations,

employee management, and customer relations o Key to success : achieving manufacturing flexibility manufacturing flexibility

  • a) physical organization of production facilities

  • b) employment of automated technologies

    • a. computer numerical controlled (CNC) machines,

    • b. computer integrated manufacturing (CIM)

    • c. automated storage and retrieval

    • d. systems (AS/RS)

    • e. robotics

    • f. computer-aided design (CAD

    • g. computer-aided manufacturing (CAM).

  • examines problems associated with applying standard cost accounting techniques in a highly automated environment.

  • The key features of two alternative accounting models are discussed:


(1) activity-based costing (ABC)


(2) value stream accounting.

  • Discussion of the information systems commonly associated with lean manufacturing and world-class companies o Materials requirements planning (MRP) systems

    • to determine how much raw materials are required to fulfill production orders

The Traditional Manufacturing Environment

The conversion cycle consists of o physical activities

o information activities

The Production system


Involves the planning, scheduling, and control of the physical product through the manufacturing process

(Show figure)


is triggered by customer orders from

the revenue cycle and//or by sales forecasts from marketing

  • Inputs trigger:

    • set a production target

    • prepare a production plan

  • Purchase requisitions(purchases procedures), Labor (payroll), Manufacturing costs WIP & FG (GL & FS)

  • Production methods{ {depende sa product na imanufacture mo}}

    • 1. Continuous processing - homogeneous product (cement)

    • 2. Make-to-order processing

      • discrete products

      • initiated by sales orders rather than depleted inventory levels

  • 3. Batch processing

    • Each item in the batch is similar

    • most common (cars, household appliances, canned goods, tires, and books)


    Figure 7-2 gives a conceptual overview

    batch processing system, which consists of four basic processes

    • 1. plan and control production

    • 2. perform production operations

    • 3. maintain inventory control

    • 4. perform cost accounting

    Documents in the Batch Processing System

    Figure 7-2 gives a concept overview- triggered by a sales forecast marketing system gives marketing may produce a forecast (annual or shorter period) Documents in the batch processing system 1. Production schedule formal plan and authorization to begin production

    describes the specific products to be made, the quantities to be produced in each batch, and the manufacturing timetable for starting and completing production

    • 2. Bill of materials specifies the types and quantities of the raw material (RM) and subassemblies used in producing a single unit of finished product RM requirements for entire batch = = BOM x number of items in the batch

    • 3. Route Sheet

    shows the production path that a particular batch of

    product follows during manufacturing sequence of operations (machining or assembly) & standard time to each task.

    • 4. Work order (or production order) draws from BOMs and route sheets to specify the materials and production (machining, assembly, and so on) for each batch. These, together with move tickets

    (described next), initiate the manufacturing process in the production departments.

    • 5. Move Ticket

    records work done in each work center and authorizes the movement of the job or batch from one work center to the next.

    • 6. Materials Requisition

    authorizes the storekeeper to release materials (and subassemblies) to individuals or work centers in the production process specifies only standard quantities separate requisitions - Materials needed in excess of standard amts require this less than the standard amt material is used, the work centers return the unused materials to the storeroom

    accompanied by a materials return ticket Batch Production Activities

    Production Planning and Control o Materials and operations requirements o Production scheduling Materials and Operations Requirements o Materials requirement the difference between what is needed and what is available in inventory o Operations requirements the assembly and/or manufacturing activities to be applied to the product Production Scheduling o Coordinates the production of multiple batches

    Influenced by time constraints, batch size, and other specifications Work Centers and Storekeeping


    o Production operations begin when work centers obtain raw materials from storekeeping. It ends with the completed product being sent to the


    finished goods (FG) warehouse .

    Figure 7-9 physical view of the batch processing system

    o organization functions, tasks performed in each function, documents trigger or result from each task Many organizations today, however, make this data transfer digitally via computerized systems that use data entry screens

    or capture data by

    scanning bar code tags

    we examine three of the four conversion cycle processes


    - consists of two main



    RM requirement for a batch

    == Inventory Need

    Inventory Available

    • info comes from analysis of inventory on hand, the sales forecast, engineering specifications , and BOM

    • operations requirements for the batch involve the assembly and/or manufacturing activities that will be applied to the product

      • determined by assessing route sheet

    specifications. 2. PRODUCTION SCHEDULING

    • master schedule for a production run coordinates the production of many different batches

      • influenced by time constraints, batch size, and specifications derived from BOMs and route sheets

    • produces work orders, move tickets, and materials requisitions for each batch in the production run

      • copy of each work order is sent to cost accounting to set up a new work-in-process (WIP) account for the batch

      • enter the production process and flow through the various work centers [in accordance with the route sheet]


    • The actual production operations begin when workers obtain raw materials from storekeeping in exchange for materials requisitions

    • M,L, MOH applied according to

    work order
    work order
    • When the task is complete at a particular work center, the

    move ticket
    move ticket

    , which authorizes the batch to proceed to the next work center

    supervisor or other authorized person signs the


    FOR EVIDENCE : copy of the move ticket is sent back to


    production planning and control to update the

    open work


    order file

    (ma-close ito kapag nareceive na ang last move



    The finished product along with a copy of the work order


    is sent to the finished goods (FG) warehouse copy of the work order is sent to inventory control to update the FG inventory records.

    • Work centers also fulfill an important role in recording labor time costs. is handled by work center supervisors who, at the end of


    each workweek, send

    • employee time cards -- payroll departments

    • job tickets -----------cost accounting departments


    • OBJECTIVE : to minimize total inventory cost while ensuring that adequate inventories exist to meet current demand

    • consists of three main activities

      • provides production planning & control with status reports on FG and RM inventory.

      • continually involved in updating the RM inventory records from materials requisitions, excess materials requisitions, and materials return tickets

      • upon receipt of the work order from the last work center, inventory control records the completed production by updating the finished goods inventory records.

  • Inventory models used to achieve objective help answer two fundamental questions:

    • 1. When should inventory be purchased?

    • 2. How much inventory should be purchased?

  • How much inventory should be purchased?

    economic order quantity (EOQ) model

    • OBJECTIVE: to reduce total inventory costs

    • is based on simplifying assumptions that may not reflect the economic reality

      • 1. Demand for the product is constant & known with certainty.

      • 2. The lead time is known and constant.

        • the time between placing an order for inventory and its arrival


    The total cost per year of placing orders is a variable that decreases as the quantities ordered increase.

    • Ordering costs include the cost of preparing documentation, contacting vendors, processing inventory receipts, maintaining vendor accounts, and writing checks.

    • 5. The total cost per year of holding inventories (carrying costs) is a variable that increases as the quantities ordered increase.

      • These costs include the opportunity cost of invested funds, storage costs, property taxes, and insurance.

    • 6. There are no quantity discounts

      • Therefore, the total purchase price of inventory for the year is constant.

    • significant parameters in this model are the carrying costs and the ordering costs.


    Parameters sets the conditions of its operation.

    • Figure 7- 10 pagmas marami ang order mo, mabawasan ang times na mag order ka, bale yung annual ordering cost mo ay mababwasan pagmas marami ang order mo, mas marami kang inventory on hand, bale magtaas yung annual inventory carrying cost mo. Dahil yung PURCHASE price natin ay constant, ang gagawin natin ay babawasan ang ordering cost at carrying cost.




    4. The total cost per year of placing orders is a variable that decreases as the


    Q = economic order quantity D = annual demand in units S = the fixed cost of placing each order H = the holding or carrying cost per unit per year

    Example : annual demand of 2,000 units, a per-unit order cost of $12, and a carrying cost per unit of 40 cents

    ROP = Lead time x Daily Demand

    Daily Demand = Total Demand // number of working days

    • Figure 7- 11 INVENTORY USAGE based on the assumptions of the EOQ model

      • Q and ROP are calculated separately for each type of inventory item

      • When inventory is reduced by sales or used in production, its new quantity on hand (QOH) is compared to its ROP

      • When QOH = ROP, an order is placed for the amount of Q

      • Yung sa example when inventory drops to 40 units, the firm orders 346 units.

  • If the parameters DAILY DEMAND and LEAD TIME are stable

    • organization should receive the ordered inventories just as the quantity on hand reaches zero

  • If either or both DAILY DEMAND and LEAD TIME are subject to variation o additional inventories called safety stock must be added to the reorder point to avoid unanticipated stockout events.

    • Stock-outs result in either lost sales or back-orders.

    • back-order is a customer order that cannot be filled

  • because of a stock-out and will remain unfilled until the supplier receives replenishment stock When an organizations inventory usage and delivery patterns depart significantly from the assumptions of the EOQ model, more

    sophisticated models such as the back-order quantity model and the production order quantity model may be used.

    Cost Accounting Activities

    Cost accounting activities of the conversion cycle

    record the financial effects of the physical events that are occurring in the production process.


    Internal Controls

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

    • Segregation of duties o production planning and control department is separate from the work centers o inventory control is 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


    • Supervision

    o work center supervisors oversee the usage of raw materials to ensure that all released materials are used in production and waste is minimized employee time cards and job tickets are checked for accuracy


    • Access control


    direct access to assets

    • controlled access to storerooms, production work centers, and finished goods warehouses


    • quantities in excess of standard amounts require approval indirect access to assets

    • controlled use of materials requisitions, excess materials requisitions, and employee time cards

    • Independent verification o 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 o internal and external auditors periodically verify the raw materials and FGs inventories through a physical count

    World-Class Companies and Lean Manufacturing

    • continuously pursue improvements in all aspects of their operations, including manufacturing procedures

    • are highly customer oriented

    • have undergone fundamental changes from the traditional production model

    • often adopt a lean manufacturing model

    Principles of Lean Manufacturing

    Pull Processing products are pulled from the consumer end (demand), not pushed from the production end (supply)

    Perfect Quality pull processing requires zero defects in raw material, WIP, and FG inventories Waste Minimization activities that do not add value or maximize the use of scarce resources are eliminated Inventory Reduction hallmark of lean manufacturing

    • Inventories cost money

    • Inventories can mask production problems

    • Inventories can precipitate overproduction

    Production Flexibility reduce setup time to a minimum, allowing for a greater diversity of products, without sacrificing efficiency Established Supplier Relations late deliveries, defective raw materials, or incorrect orders will shut down production since there are inventory reserves Team Attitude each employee must be vigilant of problems that threaten the continuous flow of the production line

    Lean Manufacturing Model

    Achieve production flexibility by means of:

    • Changes in the physical organization of production facilities

    • Employment of automated technologies

      • CIM, AS/RS, robotics, CAD, and CAM

    • Use of alternative accounting models

      • ABC and value stream accounting

    • Use of advanced information systems

      • MRP, MRPII, ERP, and EDIturing Model

    Physical Reorganization of the Production Facilities

    • Inefficiencies in traditional plant layouts increase handling costs, conversion time, and excess inventories.

    • Employees tend to feel ownership over their stations, contrary to the team concept.

    • Reorganization is based on flows through cells which shorten the physical distance between activities. o This reduces setup and processing time, handling costs, and inventories.

    Automating Manufacturing

    • Traditional Approach to Automation

      • 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 numerical controlled (CNC) machines that can perform multiple operations with less human involvement

  • Computer Numerical Controlled (CNC ) Machines

    • Reduce the complexity of the physical layout

    • Arranged in groups and from start to finish

    • Need less set-up time

  • in cells to produce an entire part

    • Computer Integrated Manufacturing (CIM)

      • A completely automated environment which employs automated storage and retrieval systems (AS/RS) and robotics

    • Automated Storage and Retrieval Systems (AS/RS)

      • Replaces traditional forklifts and their human operators with computer-controlled conveyor systems

      • Reduce errors, improved inventory control, and lower storage costs

  • Robotics

    • Use special CNC machines that are useful in performing hazardous, difficult, and monotonous tasks

  • Computer-Aided Design (CAD)

    • Increases engineersproductivity

    • Improves accuracy

    • Allows firms to be more responsive to market demands

    • Interfaces with CAM and MRPII systems

  • Computer Aided Manufacturing (CAM)

    • Uses computers to control the physical manufacturing process

    • Provides greater precision, speed, and control than human production processes

    Whats Wrong with Traditional Accounting Information?

    • Inaccurate cost allocations automation changes the relationship between direct labor, direct materials, and overhead cost

    • Promotes nonlean behavior incentives to produce large batches and inventories, and conceal waste in overhead allocations

    • Time lag data lag due to assumption that control can be applied after the fact to correct errors

    • Financial orientation dollars as the standard unit of measure 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