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
system
• Accounting controls in a traditional environment
• Principles, operating features, and technologies of lean
manufacturing
• Shortcomings of traditional accounting methods in the world-
class environment
• Key features of activity based costing and value stream
accounting
• Information systems of lean manufacturing and world-class
companies
The Conversion Cycle
• Transforms input resources, raw materials,
labor, and overhead into finished products or
services for sale
• Consists of two subsystems:
• Physical activities – the production system
• Information activities – the cost accounting
system
 Conversion Cycle in Relation to Other Cycles

Marketing
System

Sales
Forecast

Purchase Requisitions
Revenue Cycle Sales Orders
Conversion Expenditure
Cycle Cycle
Labor Usage

Work
Finished
In
Goods
Process

General Ledger
and Financial
Reporting 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
production
• 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.
• Make-to-Order Processing involves the fabrication of
discrete products in accordance with customer
specifications.
Overview: Traditional Batch
Production Model…
• consists of four basic processes:
• plan and control production
• perform production operations
• maintain inventory control
• perform cost accounting
Batch Production System
• Production Planning and Control
• Materials and operations requirements
• Production scheduling
• Materials and Operations Requirements
• Materials requirement – the difference between what is needed and
what is available in inventory
• Operations requirements – the assembly and/or manufacturing
activities to be applied to the product
Batch Production System
• Production Scheduling
• Coordinates the production of multiple batches
• Influenced by time constraints, batch size, and other specifications
• Work Centers and Storekeeping
• Production operations begin when work centers obtain raw
materials from storekeeping.
• It ends with the completed product being sent to the finished
goods (FG) warehouse .
Batch Production System
• Inventory Control
• Objective: minimize total inventory cost while ensuring that
adequate inventories exist of production demand
• Provides production planning and control with status of finished
goods and raw materials inventory
• Continually updates the raw material inventory during production
process
• Upon completion of production, updates finished goods inventory
EOQ Inventory Model
• 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
INVENTORY LEVEL

Inventory Cycle Daily Demand

EOQ

Reorder
Point

Lead Time Time (days)

Information: 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
Information: 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 the BOM and route sheet to
specify the exact materials and production
processes for each batch
Information: 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 process
 Production Planning and Control
Sales Forecast
Raw Materials Requirements
Inventory Status Report (Purchase Requisitions)

Engineering Specifications
BOM and Route Sheets Operations Requirements

Production Scheduling
Work Orders
Move Tickets
Materials Requisitions
Open Work Orders
Work Centers
Job Tickets Cost Accounting
Time Cards Payroll
Completed Move Tickets Prod. Plan. and Control
 Upon Completion of the Production Process…
Finished Product Finished Goods Warehouse
and Closed Work Order

Closed Work Order

Inventory Control
Status Report of Raw Materials
and Finished Goods Prod. Plan. and Control

Journal Voucher General Ledger

Cost Accounting System
• Records the financial effects of the events
occurring in the production process
• Initiated by the work order
• Cost accounting clerk creates a new cost
record for the batch and files in WIP file
• 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

COST ACCOUNTANTS
Update WIP accounts
STANDARDS DL
DM
Mfg. OH.
Compute Variances
Cost Accounting System
• Receipt of last move ticket signals
completion of the production process
• clerk removes the cost sheet from WIP
file
• 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
on sales forecast and the finished goods on
hand
• move tickets – signatures from each work
station authorize the movement of the batch
through the work centers
• materials requisitions – authorize the
warehouse to release materials to the work
centers
Internal Controls
• Segregation of duties
• production planning and control department is
separate from the work centers
• inventory control is 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
• work center supervisors oversee the usage of
raw materials 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
• controlled access to storerooms, production
work centers, and finished goods warehouses
• quantities in excess of standard amounts require
approval
• indirect access to assets
• controlled use of 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 finished goods files
 Internal Controls
• Independent verification
• cost accounting reconciles material usage (material
requisitions) and labor usage (job tickets) with standards
• variances are investigated
• GL dept. verifies movement from WIP to FG by reconciling
journal vouchers from cost accounting and inventory
subsidiary ledgers from inventory control
• internal and external auditors periodically verify the raw
materials and FGs inventories through a physical count
World-Class Companies…
• 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
Principles of Lean
Manufacturing
• 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 EDI
 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.
• This reduces setup and processing time, handling costs, and inventories.
 Progression of Automation in
the Manufacturing Process

Traditional Islands of Computer

Technology Integrated
Manufacturing

Progression of Automation toward World-Class Status

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
Automating Manufacturing
• 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
Automating Manufacturing
• 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
Computer-Integrated
Manufacturing (CIM) System
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
demands
• 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
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 improving operations and products
• encourage the adoption of value-added activities and processes and
identify those that do not add value
• efficiently support multiple users with both financial and nonfinancial
information
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
ABC – Pros and Cons
• Advantages
• 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
• Disadvantages
• Too time-consuming and complicated to be practical
• Promotes complex bureaucracies in conflict with lean manufacturing
philosophy
Value Stream Accounting
• Value stream – all the steps in a process that are essential to
producing a product
• Value streams cut across functions and departments
• Captures costs by value stream rather than by department or
activity
• Simpler than ABC accounting
• Makes no distinction between direct and indirect costs
• Including labor costs
 Cost Assignment to Value Stream

Sales Product Warehousing Manufacturing Shipping

Planning

Production Production Cell

Materials Labor Machines

Value Stream Product Family A

Marketing and Product Support Facilities Rent &

Design Labor Distribution Expenses
Selling Expenses Maintenance

Value Stream Product Family B

Production Production Cell

Materials Labor Machines
Information Systems that
Support Lean Manufacturing
• Manufacturing Resources Planning (MRP)
• Ensures adequate raw materials for production process
• Maintains the lowest possible level of inventory on hand
• Produce production and purchasing schedules and other information
needed to control production
• MRP II
• An extension of MRP
• More than inventory management and production
scheduling – it is a system for coordinating the activities
of the entire firm
Information Systems that
Support Lean Manufacturing
• Enterprise Resource Planning (ERP) Systems
• 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