Chapter 14

The Production Cycle

14-1
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 Learning Objectives

 Describe the major business activities and related

information processing operations performed in the
production cycle.

 Identify major threats in the production cycle and

evaluate the adequacy of various control procedures for
dealing with those threats.

 Explain how a company’s cost accounting system can

help it achieve its manufacturing goals.

 Discuss the key decisions that must be made in the

production cycle and identify the information required to
make those decisions.

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 Production Cycle

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 The Production Cycle

 Business activities and information processing activities

 Related to manufacturing of products

 Information flows to the production cycle from other

cycles, e.g.:
 The revenue cycle provides information on customer orders
and sales forecasts for use in planning production and
inventory levels.
 The expenditure cycle provides information about raw
materials acquisitions and overhead costs.
 The human resources/payroll cycle provides information
about labor costs and availability

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 The Production Cycle

 Information also flows from the expenditure cycle:

 The revenue cycle receives information from the production
cycle about finished goods available for sale.
 The expenditure cycle receives information about raw
materials needs.
 The human resources/payroll cycle receives information
about labor needs.
 The general ledger and reporting system receives
information about cost of goods manufactured

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 The Production Cycle

 Decisions that must be made in the production cycle

include:
 What mix of products should be produced?
 How should products be priced?
 How should resources be allocated?
 How should costs be managed and performance
evaluated?

 These decisions require cost data well beyond that

required for external financial statements.

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 The Production Cycle

 The four basic activities in the production cycle are:

 Product design
 Planning and scheduling
 Production operations
 Cost accounting

 Accountants are primarily involved in the fourth activity

(cost accounting) but must understand the other
processes well enough to design an AIS that provides
needed information and supports these activities.

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 Production Cycle Activities

1. Product design

2. Planning and
scheduling

3. Production operations

4. Cost accounting

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 Production Cycle General Threats

 Inaccurate or invalid master data

 Unauthorized disclosure of sensitive information

 Loss or destruction of data

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 Production Cycle General Controls

 Data processing integrity controls

 Restriction of access to master data

 Review of all changes to master data

 Access controls

 Encryption

 Backup and disaster recovery procedures

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 Product Design

 The objective of product design is to design a product that

strikes the optimal balance of:
 Meeting customer requirements for quality, durability, and
functionality; and
 Minimizing production costs.

 Simulation software can improve the efficiency and

effectiveness of product design.

 Key documents and forms in product design:

 Bill of Materials: Lists the components that are required to
build each product, including part numbers, descriptions,
and quantity.
 Operations List: Lists the sequence of steps required to
produce each product, including the equipment needed
and the amount of time required.
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 Product Design
 Role of the accountant in product design:
 Participate in the design, because 65−80% of product cost is
determined at this stage.
 Add value by:
(1) Designing an AIS that measures and collects the needed data.
 Information about current component usage.
 Information about machine set-up and materials-handling costs
 Data on repair and warranty costs to aid in future modification and design.

(2)Helping the design team use that data to improve profitability.

Compare current component usage with projected usage in alternate designs.

Compare current set-up and handling costs to projected costs in alternate designs.

Provide info on how design trade-offs affect total production cost and profitability

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 Product Design Threats and control

 Poor product design resulting in excess costs

 THREAT NO. 1—Poor product design

 Why is this a problem?
 Higher materials purchasing and carrying costs.
 Costs for inefficient production.
 Higher repair and warranty costs.
 Product Design Controls :
 Accurate data about the relationship between
components and finished goods.
 Analysis of warranty and repair costs to identify primary
causes of product failure to be used in re-designing
product.

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 Planning and Scheduling

 The second activity in production cycle is planning and

scheduling the production

 The objective of the planning and scheduling activity is to

develop a production plan that is efficient enough to meet
existing orders and anticipated shorter-term demand while
minimizing inventories of both raw materials and finished goods.

 There are two common approaches to production

planning:
 Manufacturing Resource Planning (MRP-II)
 Lean Manufacturing

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 Planning and Scheduling

 MRP-II is an extension of MRP inventory control systems:

 Seeks to balance existing production capacity and raw
materials needs to meet forecasted sales demands.
 Often referred to as push manufacturing.

 Lean manufacturing is an extension of the principles of

just-in-time inventory systems:
 Seeks to minimize or eliminate inventories of raw materials,
work in process, and finished goods.
 Theoretically, produces only in response to customer orders,
but in reality, there are short-run production plans.
 Often referred to as pull manufacturing

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 Planning and Scheduling

 Comparison of the two systems:

 Both plan production in advance.
 They differ in the length of the planning horizon.
 MRP-II develops plans for up to 12 months ahead.
 Lean manufacturing uses shorter planning horizons.
 Consequently:
 MRP-II is more appropriate for products with predictable
demand and a long life cycle.
 Lean manufacturing more appropriate for products with
unpredictable demand, short life cycles, and frequent
markdowns of excess inventory.

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 Planning and Scheduling

 Key documents and forms:

(1) Master production schedule

 Specifies how much of each product is to be produced during the period and
when.

 Uses information about customer orders, sales forecasts, and finished goods
inventory levels to determine production levels.

 Although plans can be modified, production plans must be frozen a few

weeks in advance to provide time to procure needed materials and labor.

 Scheduling becomes significantly more complex as the number of factories

increases.

 Raw materials needs are determined by exploding the bill of materials to

determine amount needed for current production. These amounts are
compared to available levels to determine amounts to be purchased

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 Planning and Scheduling
(2) Production order
 Authorizes production of a specified quantity of a product. It lists:
 Operations to be performed
 Quantity to be produced
 Location for delivery

 Also collects data about these activities

(3) Materials requisition

 Authorizes movement of the needed materials from the storeroom to the factory
floor.

 This document indicates:

 Production order number
 Date of issue
 Part numbers and quantities of raw materials needed (based on data in bill of materials

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 Planning and Scheduling
(4) Move ticket
 Documents the transfer of parts and materials throughout the factory.

 How can information technology help?

 Improve the efficiency of material-handling activities by using:
 Bar coding of materials to improve speed and accuracy,
 RFID tags can eliminate human intervention in the scanning
process

 Role of the accountant:

 Ensure the AIS collects and reports costs in a manner consistent with
the company’s production planning techniques

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 Planning and Scheduling Threats and control

 THREAT NO. 2—Over- or under-production

 Over-production may result in:
 Excess goods for short-run demand and potential cash flow problems.
 Obsolete inventory ‫تقادم المخزون‬.
 Under-production may result in:
 Lost sales.
 Customer dissatisfaction.
 Controls:
 More accurate production planning, including accurate and current:
 Sales forecasts
 Inventory data
 Investments in production planning.
 Regular collection of data on production performance to adjust production schedule.
 Proper authorization of production orders.
 Restriction of access to production scheduling program.
 Validity checks on production orders

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 Production Operations

 Production operations vary greatly across companies,

depending on the type of product and the degree of
automation.

 The use of various forms of IT, such as robots and computer-

controlled machinery is called computer-integrated
manufacturing (CIM).
 Can significantly reduce production costs.

 Accountants aren’t experts on CIM, but they must understand

how it affects the AIS.
 One effect is a shift from mass production to custom-order
manufacturing and the need to accumulate costs
accordingly.

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 Production Operations

 In a lean manufacturing environment, a customer order triggers

several actions:
 System first checks inventory on hand for sufficiency.
 Calculates labor needs and determines whether overtime
or temporary help will be needed.
 Based on bill of materials, determines what components
need to be ordered.
 Necessary purchase orders are sent via EDI.
 The master production schedule is adjusted to include the
new order.

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 Production Operations

 Sharing information across cycles helps companies be more

efficient by timing purchases to meet the actual demand.

 Although the nature of production processes and the extent of

CIM vary, all companies need data on:
 Raw materials used
 Labor hours expended
 Machine operations performed
 Other manufacturing overhead costs incurred

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 Production Operations Threats and
Controls
 THREAT NO. 4—Theft of inventories and fixed assets
 Why is this a problem?
 Loss of assets.
 Misstated financial data.
 Potential underproduction of inventory.
 Controls:
 Physical access to inventory should be restricted.
 All internal movement of inventory should be documented.

 THREAT NO. 5—Disruption of operations ( ‫توقف العمليات‬

 Why is this a problem?
 Disasters can disrupt functioning and destroy assets
 Controls:
 Backup power sources, such as generators and uninterruptible power supplies.
 Investigate disaster preparedness (‫ )الجاهزية‬of key suppliers and identify alternative sources
for critical components.

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 Production Operations Threats

 Theft of inventory

 Theft of fixed asset

 Poor performance

 Suboptimal investment in fixed assets

 Loss of inventory or fixed assets due to fire or other

disasters

 Disruption of operations

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 Production Operations Controls
 Physical access control  Maintaining detailed records of
fixed assets, including disposal
 Documentation of all inventory
movement  Training

 Segregation of duties—custody of  Performance reports

assets from recording and
authorization of removal  Proper approval of fixed asset
acquisitions, including use of
 Restriction of access to inventory requests for proposals to solicit
master data multiple competitive bids

 Periodic physical counts of inventory  Physical safeguards (e.g., fire

and reconciliation of those counts to sprinklers)
recorded quantities
 Insurance
 Physical inventory of all fixed assets
 Backup and disaster recovery
 Restriction of physical access to fixed plans
assets

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 Cost Accounting
 Accountants are primarily involved in the fourth activity (cost accounting)
but must understand the other processes well enough to design an AIS
that provides needed information and supports these activities.

 The objectives of cost accounting are:

 To provide information for planning, controlling, and evaluating the
performance of production operations;
 To provide accurate cost data about products for use in pricing and
product mix decisions; and
 To collect and process information used to calculate inventory and
COGS values for the financial statements.

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 Cost Accounting
 : Types of cost accounting systems
(1) Job order costing
 Assigns costs to a specific production batch or job.
 Used when the product or service consists of discretely
identifiable items
 Example: Houses
(2) Process costing
 Assigns costs to each process or work center in the
production cycle.
 Calculates the average cost for all units produced
 Used when similar goods or services are produced in mass
quantities and discrete units can’t be easily identified
 Example: Paint.

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 Cost Accounting
(3) Activity-Based Costing
 Traces costs to the activities that create them
 Uses a greater number of overhead pools
 Batch
 Product
 Organization
 Identifies cost drivers
 Cause-and-effect relationship

 Accounting for fixed assets:

 The AIS must collect and process information about the
property, plant, and equipment used in the production
cycle.
 These assets represent a significant portion of total assets for
many companies and need to be monitored as an
investment.

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 Cost Accounting

 The following information should be maintained about

each fixed asset:

 ID number  Expected life

 Serial number  Expected salvage value

 Location  Depreciation method

 Cost  Accumulated depreciation

 Acquisition date  Improvements

 Vendor info  Maintenance performed

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 Cost Accounting

 The purchase of fixed assets follows the same processes as

other purchases in the expenditure cycle (order  receive 
pay).

 But the amounts involved necessitate some modification to the

process:
 Competitive bidding
 Number of people involved
 Payment
 Controls
 Disposal

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 Cost Accounting
 A typical AIS would look something like the following:
(1) Product design

 Engineering specifications result in new records for both the bill of materials and the operations
list file.

 To create these lists, engineering accesses both files to view designs of similar products.

 They also access the general ledger and inventory files for info about alternate designs.
(2) Production planning

 The sales department enters sales forecasts and customer special order information.

 Production planning uses that information and data on current inventory levels to develop a
master production schedule.

 New records are added to the production order file to authorize the production of goods.

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 Cost Accounting

(3) Cost accounting

 New records are added to the work-in-process file to accumulate
cost data
(4) Production operations

 The list of operations to be performed is displayed at workstations.

 Instructions are also sent to the CIM interface to guide operation of

machinery and robots.

 Materials requisitions are sent to inventory stores to authorize release of

raw materials to production.

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 Cost Accounting

 Such a system can be used for a job-order or process costing

system.

 Both require that data be accumulated about:

 Raw materials
 Direct labor
 Machinery and equipment usage
 Manufacturing overhead

 The choice of method:

 Does not affect how data are collected
 Does affect how costs are assigned to products

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 Cost Accounting

 Raw material usage data:

 When production is initiated, the issuance of a materials
requisition triggers a debit (increase) to work in process and
a credit (decrease) to raw materials inventory.
 Work in process is credited and raw materials are debited
for any amounts returned to inventory.
 Many raw materials are bar coded so that usage data is
collected by scanning.
 RFID tags improve the efficiency of tracking material usage.
 Usage may be entered online for materials such as liquids
that are not conducive to tagging.

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 Cost Accounting
 Direct labor costs:
 Historically, job time tickets were used to record the time a worker spent on
each job task.
 Currently, workers may:
 Enter the data on online terminals.
 Use coded ID badges, which are run through a badge reader at the
beginning and end of each job.

 Machinery and equipment usage:

 Machinery costs make up an ever-increasing proportion of production costs.
 Data about machinery and equipment are collected at each production
step, often with data about labor costs.
 Until recently, data was collected by wiring the factory so all equipment was
linked to the computer system.
 Limits the ability to rearrange the shop floor.
 3-D simulations can be used to assess the impact of altering floor layout.

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 Cost Accounting
 Manufacturing overhead costs:
 Includes costs that can’t be easily traced to jobs or processes,
such as utilities, depreciation, supervisory salaries.
 Most of these costs are collected in the expenditure cycle.
 An exception is supervisory salaries, which are collected in the
HRM/payroll cycle

 Accountants help control overhead by assessing how product mix

changes will affect overhead costs.
 They should also identify the factors that drive the changes in
these costs.
 This information can be used to realign processes and
layout.
 Accurate and complete information about production cycle
activities are required to perform these analyses.

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 Cost Accounting Threats and Control

 THREAT 6—Inaccurate recording and processing of production activity data

 Why is this a problem?
 Diminishes effectiveness of production scheduling.
 Undermines management’s ability to monitor and control
operations.
 Controls:
 Automate data collection with RFID technology, bar code
scanners, and badge readers to ensure accurate data entry.
 Use online terminals for data entry.
 Restrict access with passwords, user IDs, and access control
matrices to prevent unauthorized changes to data.
 Use check digits, closed-loop verification, and validity checks.
 Do periodic physical counts of inventory and compare to records.
 Do periodic inspections and counts of fixed assets

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 General threats

 THREAT NO. 7: Loss, alteration, or unauthorized disclosure of data

 Why is this a problem?
 Loss or alteration of data could cause:
 Errors in external or internal reporting.
 Unauthorized disclosure of confidential information can cause:
 Unfair competition
 Loss of business

 Controls:
 All data files and key master files should be backed up regularly.
 At least one backup on site and one offsite.
 All disks and tapes should have external and internal file labels to
reduce chance of accidentally erasing important data.
 Promptly, remove all access rights of employees who quit or are fired

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 General threats

 THREAT NO. 8—Poor performance

 Why is this a problem?
 Quality control problems increase expenses and reduce
future sales.
 Controls:
 Prepare and review performance reports.

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 Production Cycle Information Needs

 In a manufacturing environment, the focus must be on total

quality management. Managers need info on:
 Defect rates
 Breakdown frequency
 Percent of finished goods needing rework
 Percent of defects discovered by customers

 Two major criticisms have been directed at traditional cost

accounting systems (job order and process):
 Overhead costs are inappropriately allocated to products.
Usually they use volume-driven bases; such as direct labor or
machine hours to apply overhead cost to product.
 Reports do not accurately reflect effects of factory
automation.

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 CRITICISM 1: INAPPROPRIATE ALLOCATION OF
OVERHEAD COSTS

 Traditional cost accounting systems use volume-driven bases such

as direct labor hours or machine hours to apply overhead.

 However, overhead does not vary with production volume.

 EXAMPLE: Purchasing costs vary with the number of purchase

orders processed.

 Allocating overhead based on output volume:

 Overstates the costs of products manufactured in large
quantities.
 Understates the costs of products manufactured in small
batches.

 Also, allocating overhead based on direct labor input can distort

costs

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 CRITICISM 1: INAPPROPRIATE ALLOCATION OF
OVERHEAD COSTS

 Example of two products:

 Product one uses:
 $5 of materials
 1 hour of labor
 5 minutes of machine time
 Product two uses:
 $5 of materials
 1 hour of labor
 42 hours of machine time on very expensive equipment

 Under a traditional cost accounting system, both

products will appear to have the same cost

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 CRITICISM 1: INAPPROPRIATE ALLOCATION OF
OVERHEAD COSTS

 Solution to criticism 1: Activity Based Costing (ABC)

 ABC can refine and improve cost allocations under either
job-order or process costing systems.
ABC traces costs to the activities that create them
and allocates them accordingly.
ABC aims to link costs to corporate strategy.
 Corporate strategy results in decisions about what goods
and services to produce.
These activities incur costs.
So corporate strategy determines costs.
 By measuring the costs of the basic activities, ABC provides
information to management for evaluating the
consequences of their decisions.

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 CRITICISM 1: INAPPROPRIATE ALLOCATION OF
OVERHEAD COSTS

 ABC vs. traditional cost systems:

 There are three significant differences between ABC and
traditional cost accounting approaches.
Tracing of overhead costs
Number of cost pools
Identification of cost drivers

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