CHAPTER 7: THE CONVERSION CYCLE
Conversion Cycle is the process of transforming or converting raw materials, labor and overhead
into finished products or services. This conversion cycle, although most apparent for manufacturing firms,
also conceptually exists in service and retail organizations.
Conversion cycle is composed of two sub-systems, namely, Physical Activities and Information
Activities.
Physical Activities refer to the production system or the production process itself
Information Activities is the cost accounting system
Conversion Cycle in Relation to other cycles
The illustration shows the interaction of conversion cycle with other business cycles – the revenue
cycle and the expenditure cycle – and that the conversion cycle is the central role is the conversion cycle.
The production starts after receiving customer order from the revenue cycle or by sales forecasts from
marketing system. Production target are set and production plan are prepared to drive the production
activities. Purchase requisitions for raw materials are sent to the purchase procedures, which prepares
the purchase orders for vendors. The payroll is then processed in the payroll system for the labor usage
in the production. Manufacturing costs associated with intermediate work-in-process and finished goods
(FG) are sent to the general ledger (GL) and financial reporting system.
There are different production methods that are used by a company depending on the type of product
being manufactured:
1. Continuous processing – As the name suggests, the flow of materials or product is continuous. It
creates a homogeneous product through a continuous series of standard procedures. This allows
the manufacturing entity to produce efficiently at a scale as well as to maintain needed finished
goods inventory level in order to meet expected sales demand. Sales forecast and inventory levels
are of importance in this method for it triggers the process and helps determine the number of
products to be produced. Some examples are production of cement and petrochemicals.
2. Make-to-order processing – this involves the fabrication of discrete products in accordance with
customer specifications. The manufacturing process begins only after a confirmed customer order
is received. This can also be referred to as a pull-type supply chain operation because the process
is being “pulled” by the demand. This process is initiated by sales orders rather than depleted
inventory levels. Make-to-order processing is usually used in specialized industries such as
construction.
3. Batch Processing – produces distinct batches of product. This method produces similar or
identical items per batch, allowing mass production in batches with only small changes on the
products. To justify the cost of setting up and retooling for each batch, the number of items in the
batch tends to be large. Most common method of production and used to manufacture products.
Examples of products produced in this type of method are toys, clothing, and textiles.
Batch Processing System has 4 basic processes:
1. Plan and Control Production – involves the planning and organization of manufacturing processes
usually done by the production manager. It includes the scheduling, inspection, coordination and
control of materials, methods, equipment, and operation time. This allows the division of work to
be properly undertaken and that every available element is utilized. Planning and control helps in
achieving the efficiency to bring about the desired manufacturing results.
2. Perform Production Operations – is the actual production of the products. Documents from the
planning and control will be transferred to the work center to initiate the process.
3. Maintain Inventory Control – is the recording and updating of inventories, from raw materials to
finished goods. It also includes monitoring if there are still adequate materials to be used in the
production.
4. Perform Cost Accounting – calculates all related costs in manufacturing the products to help plan,
budget and monitor the performance of the entity. Cost accounting also sets product pricing
policy. It also identifies what product and process are profitable and effective, and those that are
not.
Documents in the Batch Processing System
The production schedule is the formal plan and authorization to begin production. This document
describes the specific products to be made, the quantities to be produced in each batch, and the
manufacturing timetable for starting and completing production.
The bill of materials (BOM) specifies the types and quantities of the raw material (RM) and
subassemblies used in producing a single unit of finished product. The RM requirements for an entire
batch are determined by multiplying the BOM by the number of items in the batch.
A route sheet shows the production path that a particular batch of product follows during
manufacturing. It is similar conceptually to a BOM. Whereas the BOM specifies material requirements,
the route sheet specifies the sequence of operations and the standard time allocated to each task.
The work order draws from BOMs and route sheets to specify the materials and production for each
batch. These, together with move tickets, initiate the manufacturing process in the production
departments.
A 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. (Work center refers to the production department)
A materials requisition authorizes the storekeeper to release materials to individuals or work centers
in the production process. Specifies only standard quantities. Materials needed in excess of standard
amounts require separate requisitions that may be identified explicitly as excess materials requisitions.
This allows for closer control over the production process by highlighting excess material usage.
The diagram shows the processes undergone to produce products from batches and how the basic
processes of batch productions work. The input from Plan and control production comes from the sales
forecast of the Marketing System and/or Sales order from Sales Order System. The information from
both systems will identify required types and quantity of materials and the sequence of operations needed
to produce from the particular batch as presented in the Bill of Materials and Route Sheet. Then, actual
production takes place performed by the production operations (work center). The associated costs of
producing a batch will then be communicated to the HR and Payroll Systems. Information will be relayed
to the Cost Accounting through the time cards and move tickets and will be allocated to the work in
process inventory. Recording of inventory takes place in the Inventory Control, and all related postings is
done through the General Ledger System.
BATCH PRODUCTION ACTIVITES
In the Production Planning and Control, the main activity is the assessment of inventory
requirements. Inputs from this will come from the Inventory Status, Engineering Specs, Marketing sales
forecast, Bill of Materials, and Route Sheet. Important documents are prepared such as purchase
requisition, route sheet, production schedule, work order, and move tickets. These documents are
transferred to the Work Center to initiate the production activities. After the batch has completed the
process from one work center, authorized person will sign the move ticket in order to proceed to the next
work center. Then, information regarding the time spent will be recorded in the time card for the
preparation of the payroll, and the time ticket for the specific activities done will be transferred to the
cost accounting. Raw materials from Storekeeping are released to work centers for the start of the
production. Excess materials will be transferred back to the storekeeping. Related documents of the
materials will be passed to the Inventory Control for recording and updating of inventories. Same
documents will go the cost accounting. When goods are finished, Inventory will receive the information
and will update the inventory records, then work order will be filed. Journal vouchers for the raw
materials and finished goods are prepared for the inventory records and will be posted on the general
ledger.
1. PRODUCTION PLANNING AND CONTROL
Two main activities:
 MATERIALS AND OPERATIONS REQUIREMENTS
Materials requirement: the difference between what is needed and what is available in the RM
inventory. A product of this activity is the creation of purchase requisitions for additional RMs.
Operations requirement: the assembly and/or manufacturing activities that will be applied to
the product.
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PRODUCTION SCHEDULING
The 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.
2. WORK CENTERS AND STOREKEEPING
The actual production operations begin when workers obtain raw materials from storekeeping in
exchange for materials requisitions. Ends with the finished product along with a copy of the work order
being sent to the finished goods (FG) warehouse.
3. INVENTORY CONTROL
An objective of inventory control is to minimize total inventory cost while ensuring that adequate
inventories exist to meet current demand.
Three main activities:
-provides production planning and control with status reports on finished goods and raw materials
inventory
-continually updates the raw material inventory during production process
-inventory control records the completed production by updating the finished goods inventory records
To achieve the objective of the inventory control to minimize the total inventory cost while being able to
meet customer demands, two fundamental questions are needed to be answered:
1. When should inventory be purchased?
2. How much inventory should be purchased?
ECONOMIC ORDER QUANTITY
The commonly used inventory model is the Economic Order Quantity; however, this is only used
in simplifying assumptions that may not reflect the economic reality. It is the estimate of the number of
units per order that will be the least costly and provide the optimal balance between the costs of ordering
and the costs of carrying inventory. The objective of this model is to reduce the total inventory costs. As
the quantity ordered increases, however, average inventory on hand increases, causing the total annual
inventory carrying cost to increase.
To determine the EOQ, this formula is used:
2𝑄𝑂
𝐸𝑂𝑄 = √
𝐶
where: EOQ = economic order quantity in units
Q = estimated annual quantity used in units
O = estimated cost of placing one order
C = estimated cost to carry one unit in stock for one year
As the carrying cost of the inventories goes up, the cost of ordering goes down. The intersection
of these two is the EOQ, which indicates the preferred quantity of materials to be bought.
For example, a company has an annual demand of 2,000 units, a per-unit order cost of $12, and
the carrying cost per unit of $0.40. Using the formula for EOQ, we would know that the company should
purchase 346 units to meet the expected demand.
As to the question when should these be purchased, the reorder point is to be determined using the
formula: ROP = Lead time x daily demand. If the company’s daily demand is 5 units and the lead time is
8 days, then the company should order the additional units when the inventory falls to 40 units.
At this point, the entity will receive the purchased inventory as the stock reaches zero. In order to avoid
this, companies maintain inventories on hand called safety stock added on the reorder point. In this way,
if ever there would be delay in the delivery of the inventories, there would still be remaining stocks which
can be sold and would not result to stock-out.
DATA FLOWS AND PROCEDURES IN A TRADITIONAL COST ACCOUNTING SYSTEM
Before we discuss the data flows and procedures in a traditional cost accounting system, let us
first discuss what cost accounting system is.
The COST ACCOUNTING SYSTEM is a system which is used in manufacturing industries for
purpose of tracking the flow of inventory through various stages of production.
It is important to managers for cost control, estimation of cost, profitability analysis, inventory
valuation, it assists in checking inventory at each stage. It also helps in cost optimization,
understanding value of Raw Materials, Work in Process and Finished Goods Inventory,
maintaining Just in Time Inventory and it also assists in taking decisions without waiting for report.
Next, we have the elements of cost accounting which includes inventory control for material
requisitions, work centers for job tickets and completed move tickets, and the standards. The cost
accountant updates work in process accounts like Direct Materials, Direct Labor, Manufacturing
Overhead and also compute variances.
The popular inventory valuation methods are the Traditional Costing System and the Activity
Based Costing System. In the traditional costing system, single overhead rates are calculated
and are applied to each job department.
This is how data flows in traditional cost accounting system.
1. Initiated by the work order
(The cost accounting process for a given production run begins when the production
planning and control department sends a copy of the original work order to the cost
accounting department)
2. Cost accounting clerk creates a new cost record for the new batch and files in Work in
Process file
(As materials and labor are added throughout the production process, documents
reflecting these events flow to the cost accounting department. Inventory control sends
copies of material requisitions, excess materials requisitions, and materials returns)
3. The records are updated as materials and labor are used
(These documents enable cost accounting to update WIP accounts with standards
charges for direct labor, material, and manufacturing overhead)
4. Receipt of last move ticket signals the completion of production process.
(The receipt of the last move ticket for a particular batch signals the completion of the
production process and the transfer of products from WIP to FG Inventory. At this point
cost accounting closes the WIP account.
Now, let’s talk about the controls in the conversion cycle in the traditional environment.
First, we have the Transaction Authorization. The production activities are authorized by a work
order, move tickets and material requisitions.
Then, we have the Segregation of Duties. Its objective is to separate the tasks of transaction
authorization and transaction processing, and to segregate record keeping from asset custody.
The separations applied are:
1. Inventory control separate from Raw Materials and Finished Goods inventory custody.
2. Cost accounting separate from work centers.
3. General Ledger separate from other accounting functions.
Next is Supervision. Supervisors oversee the usage of Raw Materials in the production process
and review timekeeping activities.
Next, we have Access Control, where the direct access to Finished Goods, Raw Materials
stocks, and production processes are limited. Assets can be accessed indirectly through the
source documents that control them.
We also have Accounting Record. In detecting errors, locating lost batches, and performing
periodic audits, it is essential to have records such as work orders, cost sheets, move tickets, job
tickets, materials requisitions, the Work in Process file, and the Finished Goods inventory file.
Lastly, we have Independent Verification. The cost accounting function reconciles all cost of
production and the General Ledger reconciles the overall system.
WORLD-CLASS COMPANY
The traditional conversion cycle described previously represents how many manufacturing firms
operate today. But because of changes through time, manufacturers have begun to conduct
business in a dramatically different way. The term world-class defines this modern era of
business.
What is a world-class company? World-class companies must maintain strategic agility and be
able to turn on a dime. maintain strategic agility and be able to turn on a dime. It motivates and
treat employees like appreciating assets. It profitably meets the needs of its customers and its
philosophy is customer satisfaction. Lastly, world-class companies follow a philosophy of lean
manufacturing.
Lean manufacturing is in direct opposition to traditional manufacturing, wherein its goal is
improved efficiency and effectiveness in every area, including product design, supplier interaction,
factory operations, employee management, and customer relations.
The following principles characterize lean manufacturing.
1. PULL PROCESSING involves pulling products from the consumer end rather than
pushing them from the production end.
2. PERFECT QUALITY which requires zero defects in inventory.
3. WASTE MINIMIZATION where all activities that do not add value and maximize the use
of scarce resources must be eliminated
4. INVENTORY REDUCTION involves having only a few days hours of inventory on hand.
5. PRODUCTION FLEXIBILITY which allows them to produce a greater diversity of
products quickly, without sacrificing efficiency at lower volumes of production.
6. ESTABLISHED SUPPLIER RELATIONS
7. TEAM ATTITUDE. Which includes everyone in the team.
Before we discuss the accounting in a lean manufacturing, let’s talk about what is wrong with the
traditional accounting information. The traditional standard costing techniques emphasize
financial performance rather than manufacturing performance. The techniques and conventions
used do not support the objectives of lean manufacturing firms.
The most commonly cited deficiencies of standard accounting systems are:
1.INACCURATE COST ALLOCATIONS occur because overhead is assumed to be
directly related to direct labor. Using standard cost leads to distortions in a lean
environment.
2.PROMOTES NONLEAN BEHAVIOR due to incentives to produce large inventories and
conceal waste in overhead allocations.
3.TIME LAG as standard cost data are historic in nature. After-the-fact information is too
late to be useful in a lean environment.
4.FINANCIAL ORIENTATION is not always suitable for evaluations pertaining to
functionality and improvements because the data use dollars as a standard unit of
measure for comparing disparate items being evaluated.
Many lean manufacturing companies have sought solutions to these problems through an
accounting model called the Activity Based Costing.
Activity Based Costing or ABC is an information system that provides managers with information
about activities and cost objects, and it assumes that activities cause costs and that products (and
other cost objects) create a demand for activities
“Activities” is the term used to describe the work performed in a firm. Examples are preparing a
purchase order or readying a product for shipping.
On the other hand, Cost objects are the reasons for performing activities. These include products,
services, vendors, and customers.
Figure (7-20) illustrates the allocation of overhead costs to products under ABC.
The first step is to determine the activity cost which are illustrated by pools. The activity cost is
then assigned to the relevant cost object by means of an activity driver. This factor measures the
activity consumption by the cost object. Traditional accounting systems often use only one activity
driver whereas activity-based costing may have dozens of activity cost pools, each with a unique
activity driver.
Let’s talk about the advantages and disadvantages of Activity Based Costing.
Its advantages are:
 More accurate costing of products/services, customers, and distribution channels
 Identifying the most and least profitable products and customers
 Accurately tracking costs of activities and processes
 Equipping managers with cost intelligence to drive continuous improvements
 Facilitating better marketing mix
 Identifying waste and non-value-added activities
Its disadvantages are:
o
o
Too time-consuming and complicated to be practical
Promotes complex bureaucracies.
Now, let’s moved on to Value Stream Accounting. As the name implies, value stream accounting
captures costs by value stream rather than by department or activity.
In the illustration, notice that value streams cut across functional and departmental lines to include
costs related to marketing, selling expenses, product design, engineering, materials purchasing,
distribution, and more. An essential aspect in implementing value stream accounting is defining
the product family.
Product Family share common processes from the point of placing the order to shipping the
finished goods to the customer.
Value stream accounting includes all the costs associated with the product family, but makes no
distinction between direct costs and indirect costs. Raw Material costs are calculated based on
how much material has been purchased for the value stream rather than tracking the input of the
raw material to specific products. On the other hand, Labor costs of employees who work in the
value stream are included whether they design, make, or simply transport the product from cell to
cell.
INFORMATION SYSTEMS THAT SUPPORT LEAN MANUFACTURING
Materials Requirement Planning (MRP) is an automated planning and control system used to support
inventory management. It is used for calculating the materials required for production, controlling
inventory, scheduling, and production. MRP develops the operations’ efficiency, flexibility and profitability
by improving product quality while minimizing material and labor costs.
Operational Objectives:
1. Ensure that adequate raw materials are available to the production process.
- It is essential to ensure that there are sufficient raw materials available to be used in the
production but there should be just enough to meet the demands of the customer so that
additional costs for the excess will be avoided.
2. Maintain the lowest possible level of inventory on hand.
- Keeping low inventory on hand reduces holding cost and preventing products to become
obsolete if stock for several months. There can also be inventories which will be left unused
and would just be a waste.
3. Produce production and purchasing schedules and other information needed to control
production.
- Especially on a large company, it is important to plan and monitor the production. In this way,
there would proper allocation and utilization of resources.
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MRP is a calculation method geared toward determining how much of which raw materials are
required and when they should be ordered to fill a production order.
The primary outputs from the MRP system are Raw materials purchase requisitions that are sent
to the purchase system.
Manufacturing Resource Planning (MRP II)
•
is an extension of MRP that has evolved beyond the confines of inventory management.
•
both a system and a philosophy for coordinating a wide range of manufacturing activities.
•
integrates product manufacturing, product engineering, sales order processing, customer billing,
human resources, and related accounting functions.
MRP II is a computer-based system developed to centralize and integrate the processing of
information to be more effective for decision making. It can create a detailed production schedules from
a provided real-time data. MRP II can provide information about the company’s operating capabilities,
which can not be provided by MRP I, including machine and personnel capacity and the financial needs of
the business. This can be used as a stand-along system or can be part of another Enterprise Resources
Planning (ERP).
Benefits from a highly integrated MRP II system:
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Improved customer service
Reduced inventory investment
Increased productivity
Improved cash flow
Assistance in achieving long-term strategic goals
 Help in managing change
 Flexibility in the production process
Enterprise Resource Planning (ERP) Systems
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integrates departments and functions across a company into one system of integrated
applications that is connected to a single common database.
composed of function-specific modules that reflect industry best practices.
Electronic Data Interchange (EDI) will allow the firm to electronically receive sales orders and cash
receipts from customers, send invoices to customers, send purchase orders to vendors, receive
invoices from vendors and pay them, as well as send and receive shipping documents.
MRP I and MRP II both gave rise to ERP systems. ERP enables manufacturers to include data
beyond the scope of manufacturing process which includes sales, finance, marketing, and human
resources. It can also give information about consumer relationship management, which is often used
for service-based companies. A key principle of ERP is that instead of using, several stand-alone
systems, it creates, store and use all necessary information on a single centralized database. This
ensures that the data are complete, correct, and up-to-date.