Summary by Rosalyn Mansour
Master of Accountancy Program
University of South Florida, Summer 2002
Investment Management Main Page | JIT
Main Page | TOC Main Page
Many authors have written that, because of new advanced management techniques (AMT), traditional cost management systems (TCM) are obsolete. Such articles tend to focus only on the problems experienced when AMT meet TCMs. The purpose of Primrose’s article is to go a step further by identifying the nature of these problems so that the reader may chose alternative approaches.
Investment Appraisal
Many costing problems originate with the investment decision. Cash flows tend to be incorrectly estimated because intangible benefits of AMT are not considered. All intangible costs should be identified, quantified, and tracked in the costing system. Otherwise, there is a risk that very good projects will be passed over. In particular, the benefits and costs associated with the implementation of Just-In-Time (JIT) systems are often overlooked because JIT is not normally viewed as an investment. As a result, any negative outcomes (costs exceed benefits) may cause management to think that the costing system is inadequate.
In many cases, there would have been no justification to implement JIT. For example, the author explains, "to provide the flexibility needed to cope with the reduced lead times associated with JIT, the company has to invest in additional capacity" (50).
Replacement Decisions
Investments in Property, Plant, & Equipment (PPE) are often evaluated by themselves instead of considering how they will affect the existing infrastructure. When the investment is to replace existing PPE, there can be many different choices and each choice should be evaluated in relation to the others. One should evaluate the least expensive choice first and then proceed through the evaluation options in sequence from the lowest to the highest cost option. The least expensive option is evaluated first because it often provides many of the features sought. The idea is to look at the additional benefits received by each alternative to see if the additional cost is justified. The author provides a detailed example of how the replacement decision should occur. See below for a synopsis of this example.
The example provided by the author includes 4 investment options.
Option 1 : No investment. Still have to do annual maintenance of $4000 and will have scrap of $6000 annually.
Option 2 : Invest in 2 manual machines @ $20,000 each.
Option 3 : Invest in 1 computerized (NCN) machine @ $80,000. Requires 2 less operators than used in Option 2.
Option 4 : Invest in 1 flexible manufacturing module (FMM) @ $150,000. Requires 1 less operator than the machine in option 3.
Comparison of each alternative – least to most expensive. Cash flows provided are calculated as the sum of capital costs + capital avoided + other savings. The best option is highlighted.
| Option | Year 0 | Year 1 | Year 2 | Year 3-10 | IRR % |
| 1 | (10,000)(A) | (10,000)(A) | (10,000)(A) | (10,000)(A) | NA |
| 2 | (40,000)(B) | 10,000(E) | 10,000(E) | 10,000(E) | 21.40 |
| 3 | (40,000)(C) | 20,000(F) | 20,000(F) | 20,000(F) | 49.00 |
| 4 | 70,000(D) | 10,000(G) | 10,000(G) | 10,000(G) | 7.00 |
(A) $4,000 annual maintenance + $6,000 annual scrap.
(B) Cost of 2 machines @ $20,000 each = capital cost.
(C) Capital Cost: ($80,000) less Capital avoided: 40,000 = ($40,000)
(D) Capital Cost : ($150,000) less Capital Avoided: 80,000 = ($70,000)
(E) Savings of $10,000 saved when 2 new manual machines were purchased.
(F) Savings of $10,000 each for 2 operators not needed with the automated machines. These workers were needed with the manual machines in option 2.
(G) One less operator needed for the FMM machine than with the NCN machine.
The author notes that, had the options been evaluated by themselves, completely different IRR’s would have been calculated and a different investment decision most likely would result.
Subsequent and Delayed Projects
With AMT projects, it is assumed that there will be multiple investments needed in the future. Because AMTs involve sophisticated technology, and because technology is constantly changing, it is tempting for companies to delay investment in the hopes that greater benefits will be obtained by delaying investment. When making this decision, it is important to analyze all benefits and costs of technology investments – including those of delaying investment. Because AMT involves multiple investments, if subsequent investments aren’t made, conditions would revert back to the time of the original decision if future investment does not occur. As such, unlike the replacement decision, these types of investments must be evaluated against the option of making no investment at all and not against one another.
Machine Utilization
Future machine utilization should also be considered when making AMT investment decisions. Since AMT requires expensive investments in machines, and if machine utilization is underestimated, depreciation and standard cost can be grossly understated.
Correct estimates of machine utilization are very important when cellular manufacturing (CM) is put into place. The author defines CM by stating, "CM uses systems for coding components so that components can be classified into families that have similar machining characteristics. Cells of machines are then set up for each family" (52).
Because expensive machinery may often be underutilized, the result can be increased standard costs. To offset this increase in standard costs, all benefits related to the CM system should be identified so that the correct decision whether to implement CM is made and also to ensure that there is accurate future monitoring of the viability of the CM system. Otherwise, it could appear that a CM system is not viable, when in actuality it is.
JIT and Machine Utilization
Companies that have JIT systems experience a flux in needed capacity because either the volume of production will vary from time to time or the mix of products will vary. As such, these companies need the ability to vary output on each group of machines so that capacity is based on peak capacity. To reach peak capacity, additional machinery must be purchased. At times, actual output will be below peak capacity thereby causing the average utilization to decrease and the depreciation per hour to increase. To offset these negative affects on standard costs, all financial benefits must be identified.
Optimized production technology (OPT)
OPT helps in production control by identifying production bottlenecks and then scheduling work through them by moving excess capacity to the bottleneck. Unfortunately, most companies have moving bottlenecks called "galloping bottlenecks" (53). Therefore, investment in additional capacity is only made when it appears that a bottleneck is permanent. The objective is to ensure than average capacity exceeds average sales requirements.
Standard Costs
Management tends to misuse cost information because it is widely available, occasionally misunderstood, and often used for purposes for which it was not intended. As such, it often appears that the costing system has problems when in fact the users are using data for the wrong purposes.
Single hourly labor rates and single rates for different types of machines
Many TCMs were developed years ago when direct labor was the largest factor of production and when it did not matter if a single direct labor rate was used to calculate standard costs. Now, however, multiple direct labor rates are more appropriate as there is more variation in the cost of labor. The author explains, "Using a single cost rate means that manufacturing costs of complex products that require the use of expensive machinery are understated, while costs of simple products are overstated" (55). Obviously, the reverse would be true. If direct labor costs are incorrect, then standard costs will be incorrect and likely cause a bad decision when companies choose the prices at which they will sell their goods to consumers. It will also cause bad decisions when choosing what product mixes to produce. The company faces the same problem when it chooses one cost rate for various types of machines. Products that use more complex machines will be subsidized (standard cost is understated) by products that are less complex (standard costs is overstated).
Make vs. Buy
When standard costs are used in the make or buy decision, bias is against making the item in house because the components of standard costs are often understood by decision makers (usually engineers). For example, overhead exists whether a product is made or bought and is often overlooked in calculating the total costs of the buying alternative.
Cost reduction projects
Because many companies still use standard costs based on hourly rates, and because many decision makers don’t thoroughly understand standard costs, often companies wrongly decide that the best cost reduction method is to decrease direct labor by either increasing indirect labor or implementing AMT.
What they don’t realize is that overhead is included in standard cost, but is not eliminated when labor hours are decreased. As such, when direct labor is decreased, a larger percentage of the standard costs becomes fixed overhead. Eventually, companies are unable to keep reducing direct labor and, if flexible manufacturing systems are in place and if sales volume decreases, utilization decreases and standard cost increases while sales prices increase.
Conclusion
Often, problems arising from the use of AMT and JIT are caused by using TCMs incorrectly. The author summarizes by stating, "The problem is that companies have not updated their investment evaluation procedures to reflect how changes in technology change operations" (57).
__________________________________________
Related summaries:
Baggaley, B. and B. Maskell. 2003. Value stream management for lean companies, Part I. Journal of Cost Management (March/April): 23-27. (Summary).
Baggaley, B. and B. Maskell. 2003. Value stream management for lean companies, Part II. Journal of Cost Management (May/June): 24-30. (Summary).
Borthick, A. F., P. L. Bowen, and M. C. Sullivan. 1998. Controlling JIT II: Making the system monitor itself. Journal of Cost Management (July/August): 33-41. (Summary).
Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced Manufacturing: The CAM-I Conceptual Design. Boston: Harvard Business School Press. (Summary).
Carr, L. P. and C. D. Ittner. 1992. Measuring the cost of ownership. Journal of Cost Management (Fall): 42-51. (Summary).
Carr, L. P., W. C. Lawler and J. K. Shank. 2002. Reconfiguring the value chain: Levi's personal pair. Journal of Cost Management (November/December): 9-17. (Summary).
Castellano, J. F. and R. Burrows. 2011. Relevance lost: The practice/classroom gap. Management Accounting Quarterly (Winter): 41-48. (Summary).
Cherry, K. 1993. Why aren't more investments profitable? Journal of Cost Management (Summer): 28-37. (Summary).
Clinton, B. D., and H. Ko-Cheng. 1997. JIT and the balanced scorecard: Linking manufacturing control to management control. Management Accounting (September): 18-24. (Summary).
Crusoe, J., G. Schmelzle, and T. E. Buttross. 1999. The hidden costs of adopting JIT manufacturing. Journal of Cost Management (December): 23-26. (Summary).
Davenport, T. H. and J. Glaser. 2002. Just-in-time delivery comes to knowledge management. Harvard Business Review (July): 107-111. (Summary).
Deluzio, M. C. 1993. Management accounting in a just-in-time environment. Journal of Cost Management (Winter): 6-15. (Summary).
Deluzio, M. C. 1993. The tools of just-in-time. Journal of Cost Management (Summer): 13-20. (Summary).
Foster, G. and C. T. Horngren. 1987. Cost accounting and cost management in a JIT environment. Management Accounting (June): 19-25. (Summary).
Fullerton, R. R. 2003. Performance measurement and reward systems in JIT and non-JIT firms. Cost Management (November/December): 40-47. (Summary).
Fullerton, R. R. and C. S. McWatters. 2002. The role of performance measures and incentive systems in relation to the degree of JIT implementation. Accounting, Organizations and Society 27(8): 711-735. (Summary).
Goodson, R. E. 2002. Read a plant - fast. Harvard Business Review (May): 105-113. (How the rapid plant assessment (RPA) process can tell you if a factory is truly lean in as little as 30 minutes. The process includes two tools: The RPA rating sheet includes 11 categories for assessing leanness, and the RPA questionnaire includes 20 yes or no questions). (Summary).
Hayes, R. H. and W. J. Abernathy. 2007. Managing our way to economic decline. Harvard Business Review (July-August): 138-149. (This is a reprint of their 1980 article with a retrospect by Hayes on page 141). (Summary).
Kalagnanam, S. S. and R. M. Lindsay. 1998. The use of organic models of control in JIT firms: Generalising Woodward's findings to modern manufacturing practices. Accounting, Organizations and Society 24(1): 1-30. (Summary).
Lee, J. Y. and J. K. Winch. 1998. From push to pull: Management's control system modification for manufacturing change. Advances in Management Accounting (6): 75-92. (Summary).
Lessner, J. 1989. Performance measurement in a just-in-time environment: Can traditional performance measurements still be used? Journal of Cost Management (Fall): 23-28. (Summary).
McIlhattan, R. D. 1987. How cost management systems can support the JIT philosophy. Management Accounting (September): 20-26. (Summary).
O'Brien, J. and K. Sivaramakrishnan. 1994. Accounting for JIT: A cycle time-based approach. Journal of Cost Management (Fall): 63-70. (Summary).
Patell, J. M. 1987. Adapting a Cost accounting system to just-in-time manufacturing: The Hewlett-Packard Personal Office Computer Division. Accounting & Management Field Study Perspectives, edited by William J. Bruns, Jr. and R. S. Kaplan. Harvard Business School Press: 229-267. (Summary).
Swenson, D. W. and J. Cassidy. 1993. The effect of JIT on management accounting. Journal of Cost Management (Spring): 39-47. (Summary).
Vollmann, T. 1990. Changing manufacturing performance measurements. Proceedings of the Third Annual Management Accounting Symposium. Sarasota: American Accounting Association: 53-62. (Summary).