Chapter 7

Chapter 7
The Conversion Cycle
Objectives for Chapter 7
• Elements and procedures of a traditional production process
• Data flows and procedures in a traditional cost accounting
• 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
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 improvement in operations
and products
– encourage the adoption of value-added activities and
processes within the organization and identify those
that do not add value
– efficiently support multiple users with both financial
and nonfinancial information
The Conversion Cycle
• The conversion cycle transforms input
resources, raw materials, labor, and
overhead into finished products or
services for sale.
• The conversion cycle consists of two
– 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
– 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. Each item in
the batch is similar.
• 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 information from 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
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
prod. plan. and control
Upon Completion of the Production Process…
Finished Product
and Closed Work Order
Finished Goods Warehouse
Closed Work Order
Inventory Control
status report of raw materials
and finished goods
Prod. Plan. and Control
journal voucher
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
Q = economic order quantity
D = annual demand in units
S = fixed cost of placing each order
H = holding or carrying cost per unit per year
EOQ Inventory Model
Inventory Cycle
Daily Demand
Lead Time
Time (days)
Cost Accounting System
• Records the financial effects of the
events occurring in the production
• Initiated by the work order
• Cost accounting clerk creates a new cost
record for the new batch and files in WIP
• The records are updated as materials
and labor are used
Elements of the Cost Accounting System
Inventory Control
Work Centers
materials requisitions
job tickets
completed move tickets
Update WIP accounts
Mfg. OH.
Compute Variances
Cost Accounting System
• Receipt of last move ticket signals
completion of the production
– clerk removes the cost sheet from WIP
– 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 upon sales forecast and the finished
goods on hand
– move tickets (with authorized signature
from each work station) authorize the
movement of the batch through the various
work centers
– materials requisitions authorize the
warehouse to release materials to the work
Internal Controls
• Segregation of duties
– production planning and control
department is separate from the work
– 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 FGs files
Internal Controls
• Independent verification
– cost accounting reconciles material usage (material
requisitions) and labor usage (job tickets) with prescribed
standards, and variances are investigated
– GL dept. verifies the total movement from WIP to FG by
reconciling journal vouchers from cost accounting and
inventory subsidiary ledger summaries from inventory
– internal and external auditors periodically verify the raw
materials and FGs inventories on hand through a physical
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
• The inefficiencies inherent in the layout of
traditional plants add handling costs, conversion,
time, and excess inventories to the manufacturing
• 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
Progression of Automation toward World-Class Status
Automation of the Manufacturing
• Traditional:
– consists of many different types of machines which
require a lot of setup time
– machines and operators are organized in functional
– WIP follows a circuitous route through the different
• Islands of Technology:
– stand alone islands which employ computer
numerical controlled (CNC) machines that can
perform multiple operations with less human
– 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
– 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
– 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
– more than inventory management--it is a system for
coordinating the activities of the entire firm
Automating Manufacturing
• Enterprise Resource Planning (ERP)
– 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 camouflage production
• Willingness to maintain inventories can
precipitate overproduction.
How can inventories be
• 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…
• is important because poor quality is
expensive to the firm via scrap,
reworking, scheduling delays, extra
inventories to compensate for defective
parts, warranty claims, and service
• is a basis on which world-class
manufacturers compete
• can be improved though control point
methods such as statistical process
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
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
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
• Establishing links
between key activities
The World-Class Information
• is the integration of all the system’s functional and technological
– basic accounting applications
– 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
Control Issues in the WCIS
• Paperless environment - no traditional audit trail
• Automatic transactions - need assurance that:
– the system places orders only when inventory is
– inventory orders are placed only with approved
– the quantity of items ordered is correct for the needs
of the organization
– programmed procedures matching electronic
controls data before initiating payment perform
• Networking considerations