CHAPTER

Management Accounting
Information for Process and
Activity Decisions

Central Focus and Learning Objectives

This chapter looks at many factors related to process and activity
decisions. After studying this chapter, students should be able to:
1. Explain why sunk costs are not relevant costs
2. Analyze make or buy decisions
3. Demonstrate the influence of qualitative factors in making decisions
4. Compare the different types of facilities layouts
5. Explain the theory of constraints
6. Demonstrate the value of just-in-time manufacturing systems
7. Describe the concept of the cost of quality
8. Calculate the cost savings resulting from reductions in inventories,
reduction in production cycle time, production yield improvements,
and reductions in rework and defect rates.

Management Accounting Information for Process and Activity Decisions 1

Chapter overview A number of central ideas about decision making with management
accounting information are presented in this chapter. These include
determining which costs are sunk, which are avoidable, which are
relevant, and the role of qualitative factors in decision making.
These concepts are illustrated within the context of the make-buy
decision.
The relationships among process choices, activities, and costs also
are presented. Facilities layouts (product layouts, process layouts,
and cellular manufacturing) are discussed in the context of the
theory of constraints (TOC). Use of these layouts may yield cost
savings due to reductions in cycle time and inventory. Cost savings
can also be realized by improving production yields and defect
rates, and reducing rework. This chapter also includes a discussion
of cost of quality issues (costs of prevention, appraisal, internal
failure, and external failure). Finally, just-in-time manufacturing
systems are introduced; both the technical details and management
accounting implications are presented.

Teaching tips Students often have a difficult time with the notion of sunk costs
because they feel dissonance between business and personal
decisions regarding sunk costs. The instructor may wish to point
this out by saying that in personal decisions, emotion usually
comes into play; in business decisions, we tend to rely on the
economics of the situation and make the best choice without
considering the emotional consequences.
There has been a long-simmering argument between adherents of
the Theory of Constraints and Activity-Based Costing that the
TOC and ABC are inherently in conflict, or that one is clearly
superior to the other. There is really no reason why they cannot
be used together. Refer students to the ABC versus TOC: Will
Ever the Twain Meet? In Practice box.

Recommended 1. Analog Devices: The Half Life System (HBS case 190-061 and
cases teaching note 5-191- 103) relates to improving quality and
reducing cycle time.
2. Tektronix: Portable Instruments Division (A), Harvard Business
School Case #188-142.
3. Tektronix: Portable Instruments Division (B), Harvard Business
School Case #188-143.
4. Both the Tektronix cases discuss the implications of changing to
a JIT system and the implications for management accounting
systems design.
5. Texas Eastman (HBS case 9-190-039; teaching note 5-191-064)
illustrates how financial measures can support a firms total
quality management program.
6. Texas Instruments: Cost of Quality (A) and (B) (HBS cases
189-029 and 189-111 and teaching note 5-189-112) pertain to
the concept of cost of quality and implementing quality systems.

Management Accounting Information for Process and Activity Decisions 2

Chapter outline The material in this chapter integrates well with similar topics
presented in an operations management course, but provides the
added advantage of illustrating how financial gains can be assessed.
Stress again to students that the study of management accounting is
at the core of many business decisions, and that management
accountants are more frequently being called on to provide
information related to quality, flexibility and complexity in
manufacturing and service organizations.

Learning Objective 1: I. Evaluation of monetary decisions and relevant costs.

Explain why sunk
costs are not relevant
costs.
A. This section discusses the monetary implications of
decisions and the appropriate tradeoffs between costs and
benefits resulting from different alternatives. The key
question is which costs are relevant for decisions?
B. Relevant costs and revenues are those that differ across
decision alternatives. Cost and revenues that remain the
same across decisions are not considered relevant.
Relevant costs and revenues are used for forward looking,
or future decisions.
C. Sunk costs are costs of resources that have already been
committed, and regardless of what decision is made by
managers, these costs cannot be avoided. Sunk costs are
not considered relevant costs.
D. Review the Bonner Company example on relevant costs
for the decision to purchase a new machine. Note that the
purchase price of the old machine and the payments that
must be made on it are sunk costs and not relevant for the
decision. Further, Exhibit 5-2 illustrates that the relevant
cash outflows and inflows.

Learning Objective 2: II. Make or buy decisions

Analyze make or buy A. In a make or buy situation, the decision is to either make a
decisions. part or component in-house or source it from an outside
supplier.
1. Outsourcing is purchasing a product, part, or
component from an outside supplier instead of
manufacturing it in-house (insourcing).
2. Avoidable costs are those that are eliminated when a
part, a product, a product line, or a business segment
is discontinued.

Management Accounting Information for Process and Activity Decisions 3

Learning Objective 3: III. Qualitative factors such as the reputation of a supplier, can
Demonstrate the
influence of
qualitative factors in
making decisions.
Learning Objective 4: IV. There are three basic types of facilities layouts:
Compare the different
types of facilities
layouts.
Learning Objective 5: V.
Explain the theory of
constraints.
Management Accounting Information for Process and Activity Decisions 4
help influence quantitative decisions. Factors such as the
suppliers ability to meet performance standards on time are
critical to success. Some businesses have chosen to certify
suppliers. A certified supplier is a specially selected supplier
who is assured a high level of business for conforming to high
standards for quality and delivery schedules. Other qualitative
factors include transportation problems, the likelihood of labor
disputes, and any other factors which would impede the flow
of material or adversely affect quality.
A. A process layout is an organization system in which all
similar equipment or functions are grouped together.
Examples include university departments, print shops, and
automobile service stations.
B. A product layout is an organization of equipment to
accommodate the production of a specific product.
Examples include automobile assembly lines and
specialized clinics within hospitals.
C. Cellular manufacturing is the organization of the plant
into a number of cells so that within each cell, all machines
required to manufacture a group of similar products are
arranged sequentially in close proximity to each other.
D. Note Exhibit 5-5 on the arrangement of cellular
manufacturing into a horseshoe shape. This shape is used
to provide employees with the ability to observe (or to
provide visual control) how everyone is performing.
E. Manufacturing Cycle Efficiency
1. Manufacturing cycle efficiency (MCE) is a method
of assessing process efficiency based on the
relationship between actual processing time and total
production time.
a. MCE is the ratio of processing time to the sum of
processing, moving, storage, and inspection time.
b. Ratios closer to 1.0 are better, since a greater
proportion of the total time is devoted to value-
added activities.
Theory of constraints (TOC)
A. The theory of constraints holds that significant process
improvements (and consequent increases in operating
income) can be achieved by careful management of
bottleneck resources.
1. A bottleneck is any resource that impedes progress in
a process; it could be a machine, lack of raw material,
an inexperienced worker, or any other impediment to
efficient use of resources.
2. The basic steps in constraint management are
 a. Identify the bottleneck or constraint.
b. Determine the most efficient use of the constraint.
c. Subordinate all other resources to the constraint.
d. Add capacity to the constraint.
e. Identify additional bottlenecks to enhance
flexibility and throughput.
B. TOC identifies three measures to evaluate performance
1. Throughput contribution (essentially revenues less the
cost of raw material)
2. Investment
3. Operating costs (all costs except materials)
C. TOC emphasizes the short run optimization of throughput
contribution

Note to instructors: Given the close relationship among the topics in these three learning
objectives, they are covered together in the following section under the general heading of
continuous improvement, which is descriptive of the process that should be in place to
successfully implement JIT.

Learning Objective 6: VI. Continuous improvement

Demonstrate the value A. Just-in-Time Manufacturing Systems
of just-in-time 1. A just-in-time (JIT) system requires making a good or
manufacturing
systems.
Learning Objective 7:
Describe the concept
of the cost of quality.
Learning Objective 8:
Calculate the cost
savings resulting from
reductions in
inventories, especially
work-in-process
inventories, reduction
in production cycle
time, production yield
improvements, and
reductions in rework
and defect rates.
service only when the customer, internal or external,
requires it. JIT requires a product layout with a
continuous flow one with no delays, once
production begins.
2. Management accounting must support the move to JIT
by monitoring, identifying, and communicating to
decision makers the sources of delay, error, and waste.
3. Measures of a JIT systems reliability would include
these factors of manufacturing cycle effectiveness:
a. Defect rates
b. Cycle times
c. Percent of time that deliveries are on time
d. Order accuracy
e. Actual production as a percent of planned
production
f. Actual machine time available compared to
planned machine time available
B. Cost of quality
1. The cost of quality concept is actually an attempt to
measure the cost of nonconformance to specifications.
In other words, what does it cost us to do it wrong
and then fix it, rather than doing it right in the first
place. The typical cost of quality analysis focuses on
the following four categories:
a. Prevention costs (quality engineering, training, and
maintenance of standards)
b. Appraisal costs (inspection and process control

Management Accounting Information for Process and Activity Decisions 5

 monitoring)
c. Internal failure costs (the cost of defects detected
before they reach the customer, such as rework
downtime, scrap, etc.)
d. External failure costs (external failures occur when
the customer discovers the defect, or when the
manufacturer discovers a defect after the product
is in the customers hands; costs include warranty
costs, repair costs, shipping, product liability costs,
and related items)
2. A cost of quality report is an internal document which
enables management to identify those areas most in
need of attention. In the short run, it may be necessary
to increase some quality costs (e.g., inspection) to
achieve a decrease in another quality cost (e.g.,
internal failure). In the long run, total quality costs
should decrease as improvements in quality standards,
operating procedures, and raw material quality are
implemented.
C. Determination of cost savings from reductions in
inventory, quality costs, and processing time
1. Demand for inventory leads to huge costs in
organizations including the cost of handling and
storing work-in-process, in addition to the costs of
obsolescence or damage.
2. Often plants are reorganized to decrease cycle time
and reduce inventory-related costs because of the
decrease in work-in-process inventory.
3. The San Rafael Electric Corporation example
illustrates how a company improved on a number of
variables such as decreasing rework and reducing cycle
time. Students should pay particular attention to the
following:
a. Production flows under the original layout (Exhibit
5-6)
b. Production flows the new layout (Exhibit 5-7)
c. Effects on profits (Exhibit 5-8)
d. Summary of Benefits Exhibit 5-10 summarizes
the annual benefits from the change in plant layout

Management Accounting Information for Process and Activity Decisions 6

Chapter quiz

1. Costs that cannot be altered by any decision made now or in the future are called:
a. indirect costs.
b. rework costs.
c. sunk costs.
d. relevant costs.

2. Tom Terry manufactures an intricately detailed plastic and metal toy airplane. The
following unit cost data pertain to the unit cost of an airplane.

Direct materials $ 5.00

Direct labor 12.00
Manufacturing overhead (50% fixed) 10.00
Total manufacturing costs $27.00

Assume that the airplane can be purchased from an outside supplier. What is the
relevant unit cost for this make-or-buy decision?
a. $5
b. $17
c. $27
d. $22

3. Payne and McGough Corporation produces 5,000 units of WOW each for use in the
assembly of its finished products. The unit cost of part WOW is based on a production
level of 5,000 units per week as follows:

Variable Cost $20.00

Fixed Cost 10.00
Total Cost/unit $30.00

Part WOW also can be purchased from an outside supplier at $24 per unit. If part
WOW is purchased from the supplier, 40% of the fixed costs can be eliminated. If the
company purchases part WOW from the outside supplier, its operating income will:
a. increase by $30,000.
b. remain the same.
c. decrease by $30,000.
d. increase by $20,000.

4. Which of the factors below does not need to be considered when evaluating a make-
or-buy decision?
a. The book value of machinery
b. The suppliers reputation for delivering products in a timely fashion
c. The quality of the suppliers products
d. The savings from the alternative use of the production equipment

Management Accounting Information for Process and Activity Decisions 7

5. Hanlon Company has recorded the following data regarding its inventories. To
manufacture product MPC1, it takes 4 hours to move raw materials to the work-in-
process area. Transforming the raw materials into finished goods takes three
production steps of 3 hours each. The finished goods are then temporarily stored in a
storage area for 10 hours. Finally, they are inspected which takes 4 hours. Calculate
the manufacturing cycle efficiency for product MPC1.
a. 42.8%
b. 100%
c. 50.0%
d. 33.33%

6. Each of the following is a specific type of facility layout, EXCEPT:

a. cellular manufacturing.
b. procedural layout.
c. product layout.
d. process layout.

7. Which of the following statements is correct?

a. JIT and cellular manufacturing are not related to each other.
b. JIT facilitates the implementation of cellular manufacturing.
c. Cellular manufacturing facilitates the implementation of JIT.
d. JIT and cellular manufacturing mean the same thing.

8. One of the major implications of JIT manufacturing on management accounting is:

a. the clerical process of management accounting is simplified as there are fewer
inventories to monitor and report.
b. the management accounting system always costs more with a JIT system.
c. the clerical process of management accounting is made more complex as the JIT
system is a more complex manufacturing system.
d. more management accountants always have to be hired to handle the changes to
the management accounting system.

9. Which of the following quality costs are NOT considered external failure costs?
a. waste
b. returned products
c. warranty claims
d. product recalls

10. Which of the following is NOT one of the steps in implementing the theory of
constraints?
a. Identify the bottleneck or constraint.
b. Determine the most efficient use of the constraint.
c. Increase the level of use of all other resources.
d. Add capacity to the constraint.

Management Accounting Information for Process and Activity Decisions 8

Solutions to chapter quiz
1. c
2. d
3. b
4. a
5. d
6. b
7. c
8. a
9. d
10. c

Management Accounting Information for Process and Activity Decisions 9