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CASE STUDY The Case Of The Cost Accounting System "Ever since we embarked on Total Quality Management (TQM) at Chintaman Machine Works (Chintaman) 2 years ago, the truth of that old adage--the only constant in the world is change--has sunk in deeper. Standard Costing was one of our sacred cows, a system we had cut our teeth on. We may now have to abandon it in favour of a more dynamic system: Activity-Based Costing (ABC). My manufacturing chief is all for change. He argues that there are no straightforward causal assumptions on the shopfloor any more. Nor are there any linkages between the budget-driven performance measures we use today and our true competitiveness. A customer-led approach is compelling us to look at costs holistically rather than as a discrete, event-driven phenomena. But my managers are not sure if we need to abandon the cost-accounting system that we are familiar with. There is no consensus among my senior managers on how we need to change it to make our TQM-led approach more effective. Will ABC be a better system? How will it impact everything we do in the future" Komal Panth, the CEO of Chintaman, pondered over the debate that had ensued at the last Executive Committee meeting. Core Healthcare's Sushil Handa and Crompton Greaves' G.C. Srivastava offer solutions to Panth's problem. A BT Case Study. Minutes of the Meeting of Chintaman Machine Works' Executive Committee DATE: November 22, 1998 Komal Panth: Good evening, gentlemen. This meeting has been convened to sort out an issue that Rajendran had raised at our Executive Committee meeting 2 days ago. He was talking about how some of our MIS reports are running contrary to the spirit of Total Quality Management (TQM), which we adopted in 1996 in an attempt to get closer to the customer. He was making a specific reference to the variance statements generated every month by our Costing & Finance Department. Rajendran pointed out how our cost-measurement systems were proving to be a roadblock in the implementation of TQM and Just-In-Time (J-I-T) initiatives in the company. He had suggested that we dispense with the Standard Costing and Budgetary Control Systems which we have been following since the inception of the company in 1972. He maintains that if we do not introduce changes now, it could harm the company's prospects in the long run. Gentlemen, any changes to be introduced now are to be looked at in the context of our future plans. As you are all aware, we plan to automate our production system in tune with the global players in the textile machinery industry. A 5-year plan has been drawn up, which requires an investment of Rs 1,500 crore. Once we have the system in place, the next step will be to design processes that will be so stable that variances will disappear. Next, we will target product design, where most costs are effectively committed. However, Rajendran's suggestions will involve drastic change. Let's hear him out Rajendran Srinivasan: Thank you, Komal. I firmly believe that Standard Costing and Variance Analysis should not be used for cost-control and performance-evaluation in the context of TQM at Chintaman. Our current accounting system is, clearly, an attempt to manage isolated sets of events in our production. Its standards are rigid, and aimed at measuring these events rather than looking at them holistically as a post-TQM system with a new set of structures and dynamics. It merely restrains managerial action, which is inconsistent with our strategic objectives. It cannot work if we have to survive in today's globally competitive environment. Eventually, these questions will impact our future plans as well. Permit me to contradict your statement that variances will eventually disappear. I, for one, believe that variations exist in a dynamic system and, to arrive at the correct picture, our company will need a new set of measurement practices. Before I come to specific instances to reinforce my observations, let me talk briefly about how some of the changes in the external environment have impacted our operations and forced us to think differently. We have been manufacturing and marketing textile machinery since 1972. We enjoyed a 65 per cent marketshare of the Indian textile machinery industry until 1992. Location was our biggest advantage vis-à-vis our competitors. Tamil Nadu has 31 per cent share of India's spinning capacity. And while most of our competitors concentrated on weaving machinery, we specialised in spinning machinery. Our order-books were full Abdul Latif: Yes, those were the days. Customers paid us in advance, and the delivery period would stretch upto 4 years. But trouble began in 1992, when the government allowed the import of new and second-hand textile machinery Srinivasan: In fact, things took a bad turn when, in 1995-96, the Union Government slashed Customs duties from 25 to 10 per cent. European and South Korean companies made a beeline for the Indian market. Chintaman was suddenly under pressure to improve its quality and reduce delivery periods. We had to customise our production to suit the end-user's requirements. That was a new paradigm for us. Our local competitors used the opportunity to forge technological alliances with international manufacturers. Post-liberalisation, we needed to improve quality, increase flexibility to meet individual customer needs, reduce manufacturing lead-times, cut delivery cycles, bring down inventories, lower unit costs, and get closer to the customer. We implemented TQM to achieve those objectives. The results are evident. Amit Grover: One indicator is the decline--however slow--in the Cost Of Poor Quality (COPQ). Our COPQ has come down from 24 per cent 2 years ago to 20 per cent now. But we still have a long way to go. Srinivasan: True. But the key issue today is the ability of our accounting system to impose and measure standards and the variations therein. I believe that the use of Standard Costing is inducing dysfunctional managerial attitudes at Chintaman. While we have been able to deploy TQM successfully, our other managerial practices are incompatible with our new customer-led policy. Take our raw-material purchases. Let's take a look at the material price variance report generated every month, which indicates the flaws in our managerial practices and accounting systems. It calculates the difference between the price we should have paid for our raw-material purchases as per the standards fixed at the beginning of the budgetary period, and the price we actually paid. The report had been showing an overall adverse variance of 10-12 per cent on an average. In accounting terms, it was tolerable. In the last 4 months, however, this went up to 40 per cent. Again, in accounting terms, this was perfectly in order because we had stopped buying in bulk and had started buying in small quantities in order to keep stocks low as part of TQM. But, this month, the material price variance is back in the region of 15 per cent. How did this happen? Actually, our raw-material purchase practices are still not geared to the j-i-t practices that we adopted alongwith TQM. So, there was pressure on our purchasing managers to buy stocks merely in order to obtain quantity discounts and, thus, show a less unfavourable price variance. The decision was taken purely at the local procurement level. It was based on the only information available to the managers. And it was counter-productive for our TQM-based practices. Our managers still need to understand that, under TQM, we need to look differently at the supply chain in our company. One way of making them understand this is by introducing measurement systems that change our conventional way of thinking. Latif: That is interesting. If I recall correctly, Variance Analysis is an integral part of performance-evaluation for our indenting managers. No wonder they want to cover themselves even if it means hiding the flaws in purchasing practices. Srinivasan: The primary purpose of the production system in a TQM set-up is to procure raw materials at the right time, produce just when finished goods are needed, and deliver the exact quantities needed by the customer. Running the business without large inventories in stock requires an ability to produce in small batches economically. It also means improving buying practices to take in smaller amounts of stock at each cycle rather than shoring up in bulk, as our managers are currently doing. I'm sorry to say this, but we are still not thinking about TQM. I think the key problem is that the accounting system is not compelling our managers to think about TQM and the supply dynamics in the right light. At this point in time, we are still following the old methods of stock-keeping, which should have been discarded when we introduced TQM in the company. Our managers need to look at production and production-related functions differently since production overheads as a proportion of production costs must grow while direct costs decline because of better supply- chain management practices. Let us also look at the issue of set-up times. Two other variance reports which display a similar trend are labour-hour variance and fixed overhead volume variance. Efficiency variances measure labour hours input against the standard labour hours of the production achieved. Producing in smaller batches would mean that labour time is spent on machine set-ups, so that the standard hours of output will be lower in relation to the labour hour input--resulting in adverse labour-hour efficiency variances. This reflects poorly in our conventional approach towards the efficiency of supervision on the shopfloor. Today's measures, which compare the total cost of both set-up and operating time to the number of units produced, encourage production in large batches in order to reduce the proportion of time spent on machine set-ups. To encourage our people to improve and change their practices, we need performance measures which should motivate managers and workers to reduce set-up times in order to produce small batches economically. This will help lower inventories. Performance measures that benefit from large batch sizes should, therefore, be avoided. Standard Costing variances are measures that encourage the continuation of archaic management practices. They discourage our managers from learning the new dynamics of the supply chain in TQM terms, and I don't think we are heading towards any improvement per se. Grover: There may be some truth in the observation. If the adverse variances have encouraged purchasing managers to buy in bulk and, hence, pile up inventory, we need to change the way we interpret these variances. We should not use variances as a stick to beat managers with, but as part of a learning process to improve operations. Any tendency towards dysfunctional behaviour can also be checked by measuring other positive indicators, like declining inventory levels. As far as set-up times are concerned, there are 2 alternatives: exclude set-up times from the labour input side of the equation; or adopt a counter-balancing performance indicator which penalises or discourages long runs. But this would not indicate whether we have optimised set-up times at all--and may end up hiding inadequacies on this score. Srinivasan: There is another instance that I can cite. Take the fixed overhead volume variance which arises as a result of a given level of overhead expenditure being spread over a number of units. Adjusting output downwards to meet a fall in short-term demand will, however, mean fewer units to absorb the fixed overhead--resulting in an adverse volume variance. Hence, managers would be compelled to produce, in direct contravention of TQM requirements. Grover: The fixed overhead volume variance has, admittedly, no relevance for control purposes. It does not arise as a result of over- or under-spending, but due to variations in the number of units produced. Indeed, there is a strong case for not allocating non-volume-related costs to the product unit and, by implication, not including them in standard costs. Because if they are actually allocated this way, the resultant unit cost will not be the incremental cost of producing a unit and will not, therefore, be an appropriate input for decision-making. Cyrus Thanawala: I can see why Rajendran is making these points. There does seem to be reasons to believe that we need to modify our accounting practices to cater to the new TQM environment in our company. If I may summarise, for my own understanding, these issues raise a basic question about the merits of Standard Costing in an ever-changing business environment. Material and labour are volumes-related costs, and it is precisely these that Standard Costing is designed to plan and control. The technique is concerned with comparing actual costs per unit with standard costs per unit. Fixed costs imputed into the product-unit are unit costs only notionally. Any difference between the actual and standard fixed cost per unit is not, therefore, meaningful for controlling operations, as it does not reflect expenditure. It only reflects differences in production volume. What matters is the total fixed overhead expenditure rather than fixed overhead cost per unit. There is some merit in the concerns expressed by Rajendran. The major costs in a TQM environment are those related to production capacity rather than to production volume. Grover: An Activity-Based Costing (ABC) system may be more appropriate at Chintaman. It has a greater synergy with TQM than with Standard Costing. ABC focuses on activities that drive the costs in the service and support departments, which form the bulk of controllable costs. ABC does not also impute fixed costs to the product-unit. Thanawala: But then, a large proportion of our costs at Chintaman are volumes-related. Seventy per cent constitutes direct costs, which are related to the volume of production. Even some part of the overheads is volumes-led. Our material costs represent the largest percentage--55 per cent--of total manufacturing costs. Direct labour costs account for 12 per cent of the total costs. Together, they are big enough to warrant control through Standard Costing. Panth: Would it be better to operate 2 cost management systems--Standard Costing Variance Analysis for volumes-related costs and ABC for non-volumes related costs? But I am not sure if it would be worthwhile because it will lead to data diarrhoea. Srinivasan: I am not convinced that that is the right approach. Standard Costing variances have, at best, a minor role to play. And at their worst, they are counter-productive as they force managers to focus on the wrong issues. From what I've been saying, it is clear that our accounting systems are focusing on measuring events rather than on addressing the structure and dynamics of the system. I am sure they need to be changed. Let me tell you why. In a continuous improvement set-up typical of TQM, we have organised the workforce into empowered, multi-skilled teams controlling operations autonomously. There are currently about 26 such teams at work. The feedback they require must be in real-time. Periodical financial variance reports generated through Standard Costing are neither meaningful nor timely enough to facilitate appropriate control action. Thanawala: I don't agree. Periodic financial information does have a role to play in informing work-teams of the financial implications of their activities. For instance, a work-team may be aware of a problem with material yields. To improve yields, it may change the way it operates. This may result, however, in increased labour-hour consumption which may more than offset the savings in material costs. That information can only be provided by Standard Costing. Besides, if real-time feedback is required, nothing prevents us from going in for an integrated computerised manufacturing and accounting system so that we can provide cost information in real-time. Periodic financial reports also facilitate management control at a senior level by providing the overall picture. I, for one, would like to monitor the financial consequences of team activities. In addition, variance information--especially trends in variances--will be useful to all of us for planning. To say that the variance reports have no value is not correct. Srinivasan: I take the point about the necessity of reports that provide an overall picture. But there is a more fundamental issue. In a TQM environment, Standard Costing variance measurement places an emphasis on cost control. And quality practices suffer because of that. TQM requires a total managerial and worker ethos of improving and maintaining quality and resolving problems related to it. Variance analysis is likely to pull managerial and worker interest away from critical quality issues. Thus, cost control may be achieved at the expense of quality and competitive advantage. We need systems which encourage and guard against MIS-identification of the causes of problems--not just Standard Costing. Grover: In principle, I agree with Rajendran. But I certainly do not think that the issues justify the abandonment of cost control. It only reinforces the need to measure performance through a range of indicators--cost, quality, lead-times, inventory levels, and so on. Panth: What Rajendran is saying is that an environment of continuous improvement requires continuous effort to do things better, not just to work towards achieving an arbitrary standard based on prescribed or assumed conditions. Srinivasan: That, among others, is precisely the point I have been trying to make. Standard Costing based on engineering standards--which, in turn, are predicted on the notion of one best way--is only appropriate in the static, bygone world of cost-plus pricing. In such a world, a standard cost is established specifying what a product should cost, and to this is added the required profit mark-up to arrive at the selling price. Cost management only ensures that standards are adhered to. In today's competitive environment, we no longer look at the total unit cost to determine selling-price. Instead, we use the selling-price that the market will allow, and use it to determine the cost. Also, there is likely to be considerable downward pressure on this cost. Cost management must, therefore, involve both cost maintenance and continuous cost improvement. In such a competitive environment, of what value is Standard Costing based on pre-determined engineering standards? Thanawala: While, historically, engineering standards have been the norm, it does not have to be so today. Take, for instance, Kaizen, as used in Toyota plants. The essential principle of controlling unit product cost embodied in Standard Costing is preserved, the only difference being that Kaizen uses the actual production cost of the previous year as the basis for comparison rather than a pre-determined engineering standard, and a target reduction rate is applied to this. Whether this modification to traditional costing is appropriate will depend on the circumstances. In some production technologies, the scope for continuous improvements or cost reduction is limited, and maintaining standards may be the overriding imperative. Importantly, it should not be forgotten that the previous year's actual costs, on which improvement is sought, may include low efficiency levels relative to standards that may be expected in the industry. Panth: I hope that this is not looking a little too far ahead into the future. I don't think there is a consensus on the kind of cost information and control systems that we should pursue. The only option offered is ABC. Let's meet again to discuss the issue at length. Thank you, gentlemen. Is Rajendran Srinivasan right? Is Standard Costing incompatible with TQM? Does ABC have greater synergy with the goals of TQM? Should the company discard the budgetary control that has served it well for decades? Which cost information system should Chintaman adopt? How can the costing and finance department provide real-time information to empowered teams? Will Chintaman face the risk of information diarrhoea if it adopts Standard Costing for volumes-related costs and ABC for non-volumes related costs? How can such a situation be prevented? |
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