ACCA - P5 Study text - Emile Woolf INT - 2010
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long. In these situations, it is necessary to hold some inventories of finished
goods.
It might be difficult to arrange a reliable supply system with key suppliers.
2.7 Information requirements and JIT
In a JIT production and purchasing system, managers have information
requirements that are different from those of managers in traditional manufacturing
systems. In particular:
When inventory levels are small and insignificant, inventory costs are
immaterial. Costing systems such as absorption costing, whose main purpose is
to value inventory, are too complex for management information needs.
If inventories are always kept close to zero, they will always have a relatively
smallvalue.Ifinventoriesaresmallandofnomaterialvalue,thereisnovaluein
trying to keep continuous accounting records for inventory. The cost of
production and sales in any period should be very close to the material
purchases,labourcostsandotherexpensesoftheorganisation.JITsystemsma
y
therefore encourage the use of either throughput accounting or backflush
accounting.
Managers need information about bottlenecks in production that create delays
for just-in-time production.
If employees are ‘empowered’ to take more decisions themselves, the
information system must be capable of providing these employees – probably
through an online and on-demand information system – with the information
they need to take decisions about their work.
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Quality management and quality costs
The importance of quality
Quality-related costs
Managing quality-related costs
Total Quality Management (TQM)
Continuous improvement (Kaizen)
Quality circles
Potential benefits from TQM
Performance measurement for TQM
TQM and JIT compared
3 Quality management and quality costs
3.1 The importance of quality
Success in business depends on satisfying the needs of customers and meeting the
requirements of customers. An essential part of meeting customer needs is to
provide the quality that customers require. Quality is therefore an important aspect
of product design and marketing.
Quality is also important in the control of production processes. Poor quality in
production will result in losses due to rejected items and wastage rates, sales returns
by customers, repairing products sold to customers (under warranty agreements)
and the damaging effect on sales of a loss of reputation.
A company or a not-for-profit entity may have a strategic target for quality:
It may adopt a Total Quality Management (TQM) approach and look for
continuous improvements in quality. Improvements in quality do not mean
higher costs. Improvements can be found that will lower costs by improving
efficiency and eliminating waste.
It may have a strategic target for quality. For example, a company might set a
target of a maximum of 1% of goods sold to customers being returned as
unsatisfactory.
If there is a strategic target for quality, the aim should be to achieve the target for a
minimum total of quality-related costs.
Even if an entity does not have a specific quality target, it should seek to minimise
quality-related costs. In order to do this, quality-related costs should be measured,
analysed and controlled.
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3.2 Quality-related costs
Quality-related costs can be defined as: ‘the expenditure incurred in defect
prevention and appraisal activities and the losses due to internal and external
failure of a product or service, through failure to meet agreed specification’.
An organisation must incur costs to deal with quality.
It might incur costs to prevent poor quality, or detect poor quality items when
they occur.
It might incur costs in correcting the problem when poor quality does occur.
Quality costs can be classified into four categories:
prevention costs
appraisal costs
internal failure costs
external failure costs.
These categories of cost will be explained here in the context of a manufacturing
company. However, a similar analysis could be made for service companies and
not-for-profit entities.
Prevention costs
Prevention costs are the costs of action to prevent defects (or reduce the number of
defects). They are costs incurred to prevent a quality problem from arising.
Quality problems can arise for a variety of reasons:
The initial design of the product and the method of making it may be poor, so
that there will be a large number of sub-standard items produced.
The raw materials used to make the product may be poor in quality, and better-
quality raw materials may reduce the wastage rate in production.
The work force may be badly trained, and so may make a large number of errors
in production.
Faulty output may occur when the production machinery is not in good working
order, which may be caused by insufficient maintenance and repair work on the
machines.
Prevention costs are the costs incurred in preventing these problems from
happening. For example:
designing products and services with in-built quality
designing production processes of a high quality
training employees to do their jobs to a high standard.
carrying out regular maintenance check-ups on production machinery.
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Appraisal costs
In a production system, the purpose of appraisal is to prevent poor-quality work
from leaving the factory. Poor quality output should be identified in the factory, by
testing or inspection either during the production process or at the end of the
production process.
Appraisal costs are the costs of checking the quality of work that has been done.
They include inspection and testing costs.
Internal failure costs
Items that are inspected and found to be faulty will be either:
rejected and thrown out, or
re-worked so that it meets the required quality standard.
Internal failure costs are costs incurred when defective production occurs. They
include:
the variable cost of items that are scrapped when found to be sub-standard in
quality
the incremental cost of re-working items to bring them to the required quality
standard
the cost of production time lost due to failures and defects. If a factory is
working at full capacity and is unable to keep up with sales demand, this cost
would include the contribution lost as a consequence of producing less finished
output and so selling less.
External failure costs
External failure costs are costs incurred when the quality problem arises after the
goods have been delivered to the customer. They include the costs of:
dealing with customers’ complaints
the costs of carrying out repair work under a guarantee or warranty
transport costs incurred when recovering faulty items from the customer
transport costs incurred in delivering repaired items or replacement items to the
customer
the costs of recalling all items from customers in order to correct a design fault
legal costs, when a customer takes the organisation to court
the cost of lost reputation: when an organisation gets a reputation for poor
quality, customers will stop buying from it.
It is commonly argued that the biggest quality costs that an entity incurs are its
‘external failure costs’: these are the quality costs incurred after goods have been
delivered to the customer. It is impossible, however, to estimate the costs of the
sales that are lost because potential new customers choose to use a different
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supplier, having learned about the company’s reputation for poor quality or bad
service.
The aim should be to reduce quality costs. Ideally this can be done by improving
product design and production systems. If necessary, more should be invested in
identifying quality problems before they leave the factory, for example through
improvedin
spectionandtestingsystems.
3.3 Managing quality-related costs
The traditional view of managing quality costs is that the total of all quality costs
should be minimised. An organisation should spend more money on prevention
and detection costs, if this reduces internal and external failure costs by a larger
amount. On the other hand, there is no reason to spend more on preventing poor
quality if the benefits do not justify the extra cost.
This traditional view is rejected by supporters of the Total Quality Management
(TQM) principle. The TQM view is that it is impossible to identify and measure all
quality costs. In particular, it is impossible to measure the costs of lost reputation,
which will lead to a decline in sales over time. The aim should therefore always be
to work towards zero defects. To achieve zero defects, it will be necessary to spend
more money on prevention costs.
The TQM approach to quality costs is to ‘get things right the first time’.
Example
You are presented with the following list of performance measurements before the
implementation of a Total Quality Management Programme (Pre-TQM) and after its
implementation (Post-TQM).
Pre-TQM performance Post-TQM performance
% %
Returns by customers due to
packaging defects
5 2
Rejections on final inspection 6 4
Losses in production 3 1
Required
Calculate how many units must be input to the process to achieve final sales of 1,000
units:
(a) before the TQM programme
(b) after the TQM programme.
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Answer
Performance
Pre-TQM Post-TQM
units units
Sales 1,000 1,000
Packaging failures 50 20
1,050 1,020
Rejected units 67 43
1,117 1,063
Process losses 35 11
Units to be input 1,152 1,074
The TQM improvements have led to a reduction of about 7% (78/1,152) in the
quantity of units that need to be input to produce 1,000 units of output.
3.4 Total Quality Management (TQM)
It is now widely accepted that in order to succeed in business in highly competitive
markets, companies must adopt strategies aimed at satisfying the customer.
Customer needs can be satisfied to some extent by cutting costs and selling at lower
prices. However, strategies to achieve customer satisfaction must also focus on three
other critical success factors:
quality
time, and
innovation.
One approach to achieving improvements in these critical success factors is a Total
Quality Management programme.
TotalQualityManagement is a philosophy of qualitymanagement with its origins
in Japan in the 1950s. CIMA Official Terminology (2005 ed.) defines Total Quality
Management (TQM) as ‘integrated and comprehensive system of planning and
controlling all business functions so that products or services are produced which
meetorexceedcustomerex
pectations.TQMisaphilosophyofbusinessbehaviour,
embracingprinciplessuchasemployeeinvolvement,continuousimprovementatall
levelsandcustomerfocus,aswellasbeingacollectionofrelatedtechniquesaimed
atimprovingqualitysuchasfulldocumentationofactivities,cleargoal‐settingand
performancemeasurementfromthecustomerperspective.
It is important to unders
tand that TQM is a philosophy or culture.
For a TQM programme to succeed, it must have the full support of everyone in
the organisation, from senior management to lowest-paid employees.
Everyone in the organisation is actively involved in trying to achieve
improvements in processes, systems and products. Each individual accepts
personal responsibility for his or her own standards of quality.
Employees are encouraged to be involved actively in the TQM process. This is
achieved partly through the use of quality circles.
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TQM has several different aspects, including:
statistical quality control systems and
a ‘zero defects’ policy – similar to the approach in JIT
continuous improvement
quality circles.
3.5 Continuous improvement (Kaizen)
TQM applies the concept of continuous improvement (or ‘Kaizen’). Kaizen means
‘improvement in small steps’. In a continual improvement programme, the aim is to
keep on finding ways of improving performance. It is not important that each new
improvement is small. What is important, however, is that improvements should
continue all the time, and that everyone should be constantly looking for ways of
making improvements.
The ISO 9004 international quality standard describes continuous improvement as
an eight-step method:
Involve the entire organisation
Initiate quality improvement projects or activities
Investigate possible causes of quality problems
Establish cause-and-effect relationships
Take preventative or corrective action to improve quality
Confirm the improvement
Sustain the gains
Continue the improvement.
Kaizen: quality improvements and cost reductions
Kaizen has two aims. One is to improve quality without adding to cost. The other is
to reduce costs without reducing quality. The process of continuous improvement
therefore takes place within a framework of quality assurance. Checks are made to
ensure that changes do not reduce quality, because reductions in quality create a
loss in value. Loss in value reduces customer satisfaction, and this will be damaging
to the company in the long term.
Kaizen costing, which is a costing system to support Kaizen, is described later.
3.6 Quality circles
Quality circles might be used as a part of a continuous improvement programme. A
quality circle is a small group of employees, usually five to eight people, who meet
regularly to discuss work-related problems and possible solutions to them. The
main focus for discussion is on the quality of processes and work systems.
With quality circles, ordinary workers are encouraged to contribute ideas for
improvement, and so participate in the continuous improvement programme.
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Quality circles cannot replace other quality management processes and methods,
such as statistical quality control systems.
Quality circles are not used in all companies that use TQM. However, a system of
continuous improvement (Kaizen) does depend on work by teams of individuals
representing different functions and skills. For example, a team might be established
consisting of an engineer, an accountant, a person from manufacturing and a person
from the buying department. The team members then combine their knowledge and
skills to devise methods of achieving improvements in a particular aspect of
operations for which they have been given responsibility for improvement.
3.7 Potential benefits from TQM
There are several potential benefits that might be obtained from introducing a TQM
approach:
Formally establishing a TQM system will establish the importance of ‘quality’ in
a way that all employees and managers should recognise.
The commitment to quality should also establish ‘customer satisfaction’ as a
prime business objective.
A successful introduction of a TQM approach should result in continuous
improvements in all processes and operations.
However, the successful application of TQM will depend on the provision of
relevant and useful quality-related information, and in particular, information about
quality-related costs.
3.8 Performance measurement for TQM
A system of TQM and continuous improvement needs the support of an
information system that provides relevant information.
Management accounting information can be provided by the Kaizen costing
system.
There is extensive use of non-financial performance indicators, such as
production setup times, the number of times materials are moved, and the
number of units scrapped or wastage levels.
A report in the US (1993) on the use of Kaizen by Japanese manufacturing
companies commented: ‘These quantitative, non-financial measures allow
employees to monitor their performance and interpret the results of their efforts.
With relevant training and frequent reports on the company’s financial health,
companies ensure employees understand how their work directly affects the
company’s performance.’
3.9 TQM and JIT compared
Many of the concepts applied by total quality management are similar to those in a
just-in-time management philosophy.
The aim in both should be to have zero inventory. Raw materials should be
delivered from suppliers only when they are needed, and items should be
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produced only when they are required for sale to a customer. In practice, this
ideal is usually impossible to achieve, and the aim should therefore be to
minimise inventory of raw materials and finished goods.
A ‘pull system’ should therefore operate, with items being manufactured only
when they are required by customers. This is different from the traditional
‘push’ system of manufacture, when the aim was to maximise the use of
production capacity in order to minimise fully absorbed production costs per
unit.
The aim should be to create a uniform factory load and continual rate of
production, so that the speed of manufacture matches the rate of customer
demand.
The key aim should be to provide a level of quality that satisfies customers and
meets their needs.
Employees should be encouraged to participate in the TQM/JIT process.
Successful implementation of both TQM and JIT requires a flexible work force,
capable of switching from one task to another as requirements dictate.
Many JIT manufacturing systems use a factory layout that minimises the need to
move materials. Movement of materials does not add value, and should be
avoided. This is consistent with the TQM view that movement is waste.
Setup times between jobs should be minimised, because setting up does not add
value.
There should be a focus on simplification of products and processes, in order to
maximise the utilisation of available resources.
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Target costing and Kaizen costing
The purpose of target costing
The target costing method
Techniques for achieving the target cost
Kaizen costing
4 Target costing and Kaizen costing
4.1 The purpose of target costing
Target costing is a method of strategic profit management. It is used for new
product development.
An idea for a new product is proposed. The features and functions of the
product are specified – what it will do, what it should be made of, what it should
look like and so on. These features and functions may be altered later in the
process.
The company carries out market research to decide what price customers would
be willing to pay for the product. It then decides the price that it would like to
charge for the new product, in order to win a target share of the market.
The company then decides on the level of profitability that it wants to achieve
for the product, in order to make the required return on investment. This target
profit margin should reflect the company’s strategic planning objectives.
Having identified a target price and a target profit, the company then establishes
a target cost for the product. The target cost is the target selling price minus the
target profit margin. This is the cost at which the product must be manufactured
and sold in order to achieve the target profits and return at the strategic market
price.
The target cost is usually less than the cost that could reasonably be achieved
with current manufacturing methods and materials.
Achieving this cost is a target towards which everyone involved in the project
then works.
Since there is ‘gap’ between the target cost and the expected cost, the gap must be
closed by finding ways of making the product more cheaply – for example, by
simplifying the design or using a different material. However, the reductions in cost
should be achieved without reducing the quality or value of the product, because if
quality is reduced, customers will not pay the target price.
4.2 The target costing method
Target costing is based on the idea that when a new product is developed, a
company will have a reasonable idea about:
the price at which it will be able to sell the product, and