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)
o 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:
o (1) activity-based costing (ABC)
o (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) Production 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)

BATCH PROCESSING SYSTEM

 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
o 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.
o 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

(1) PRODUCTION PLANNING AND CONTROL- consists of two main

activities

1. SPECIFYING MATERIALS AND OPERATIONS REQUIREMENTS

 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]

WORK CENTERS AND STOREKEEPING

 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
 When the task is complete at a particular work center, the
supervisor or other authorized person signs the move ticket,
which authorizes the batch to proceed to the next work center
o 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
ticket)
o The finished product along with a copy of the work order
is sent to the finished goods (FG) warehouse
o 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.
o is handled by work center supervisors who, at the end of
each workweek, send
 employee time cards -- payroll departments
 job tickets -----------cost accounting departments

INVENTORY CONTROL

 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
3. All inventories in the order arrive at the same time.
 4. 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.
o Parameters – sets the conditions of its operation.
 Figure 7- 10
o pagmas marami ang order mo, mabawasan ang times na mag
order ka, bale yung annual ordering cost mo ay mababwasan
o pagmas marami ang order mo, mas marami kang inventory on
hand, bale magtaas yung annual inventory carrying cost mo.
o Dahil yung PURCHASE price natin ay constant, ang gagawin
natin ay babawasan ang ordering cost at carrying cost.

where: 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

When do we purchase

reorder point (ROP)

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 organization’s 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.

CONTROLS IN THE TRADITIONAL ENVIRONMENT

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
o 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
o employee time cards and job tickets are checked for
accuracy
 Access control
o direct access to assets
 controlled access to storerooms, production work
centers, and finished goods warehouses
 quantities in excess of standard amounts require
approval
o 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
o 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 in cells to produce an entire part
from start to finish
 Need less set-up time

 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 engineers’ productivity
 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

What’s 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