Financial and Management Accounting: Assessment Brief

This module is assessed by:

1) Report (100%) - 3,500 words - Submission Deadline: 11/02/2024

Assessment Details:

Case: Global Car Manufacturing Industry

Abstract

Using the performance of Toyota during and after the economic crisis (2007-8) versus that of the Big Three US car manufacturers, this case study presents the operational aspects and accounting tools underlying how a company adopts a cost accounting method. Toyota operates from a lean production system that is compared with and contrasted against the traditional production systems of US auto manufacturers. The case provides an overview of approaches to cost accounting: traditional, activity-based costing and lean while introducing lean accounting tools to demonstrate their impact on performance analysis and decision-making. By examining the analysis tools in traditional systems, such as the gross profit percentage and variance analysis, the case raises concerns about how such tools could be misleading. Lean accounting tools unveil significant hidden costs, which have a strong impact on performance analysis and decision-making.

Economic crisis

In 2008, the world economy crashed and so did the Big Three US car manufacturers. General Motors (GM) filed for bankruptcy, Ford Corporation reported a $12.7 Billion loss, and later in 2009, Chrysler went into bankruptcy protection. However, its Japanese counterpart, Toyota Motor Company, sustained its leadership in the car industry. Toyota Motor Company considered this headwind as a valuable opportunity to turn it into a more flexible and stronger company (The Auto Channel, 2008).

U.S. car manufacturers had structural limitations imposed on their operational flexibility. Despite lower consumer spending, the companies decided that cutting production was not the solution. They operated under a traditional manufacturing system, and because of costs, mainly inventory and labour, manufacturers had no leeway for making cuts. For example, GMs structural limitation was evident in the Arlington manufacturing site. To keep pace with technology and product innovation, GM had to build a new separate building for its body shop rather than modernize the existing facility. Thus the transfer of production from the body shop to the final assembly endured more motion and consumed more time than under optimal conditions. But, GM could not afford to shut down the site for renovation due to extensive committed labour costs. Adding to its operational inflexibility were transportation costs associated with pre-existing contracts with suppliers, 78% of which were scattered in Michigan, Canada, and Mexico (Hawkins & Shirouzu, 2006).

The labour force was unionized, and therefore protected by minimum wage, benefits, and layoff policies (UAW: United Auto Workers). UAW workers were entitled to 95% of their pay if the plants shut off, which is equivalent to $1,545 per car, health care benefits of $1,635 per car, and holiday pay of $630 per car (Taylor, 2007). The other option for the car manufacturers was to keep Detroits normal production and either sell excess inventory to car rental agencies at $3,000$5,000 discounts per vehicle damaging the resale value of used cars in the short term, or pay $1,250 per vehicle to dealers to store them (Taylor, 2007). GM and Ford each incurred close to $2 billion in leasing losses in the second quarter of 2008 (Welch, 2008). In either case, fixed and committed costs already incurred would be allocated over a larger number of units produced, reducing the cost per vehicle. However, the hidden embedded costs as deferred inventory costs and concealed actual expenses on the income statement contributed further to Big Three losses. The hidden costs are those fixed overhead costs, already incurred, but capitalized under absorption costing into inventories in compliance with US GAAP. Under these restrictions, the Big Three flooded the market with new cars, despite the sharp drop in demand. To move their inventory, manufacturers offered car dealers incentives to store the excess inventory and to push for sales.

Notwithstanding restructuring efforts, the U.S. government had to interfere to bail out the car industry. The U.S. government authorized $10 billion in aid to Chrysler, which led to its ownership of 8.6% of the companys equity (Durbin, 2011) and $50 billion to General Motors Co. which entitled the government to control 61% of its equity (Beach, 2014). Ford refused the government's offer for a bailout. At a deeper level, the question is whether GM and Fordthe companies that perfected mass production -can fundamentally change their culture to the new lean production system (Schifferes, 2007).

In 2004 GM embarked on a restructuring plan to go lean in its operations by introducing a global manufacturing system. For decades GM has been using the mass assembly-line technique, whereby each division had its own manufacturing processes, its own parts, it's own engineering, and its own stamping plants (Holstein, 2009). The new manufacturing system would use the same production procedure across the global plants. The plant's restructuring would encompass flexibility for each type of vehicle, integrating design and manufacturing to gain efficiencies. The flexibility is based on sharing a common platform, including engines and transmissions (Schifferes, 2007) for each type of car (small, medium, or truck). However, supplier relationships remained a major problem for production, which constituted 85% of car makeup. Many suppliers who were pressured to reduce cost shifted their production outside the U.S. This in turn had tremendous effects on GMs transportation costs. Ford also faced legacy cultural problems in trending towards lean production.

Further restructuring efforts were applied by the car manufacturers after government intervention in 2008. All of the restructuring involved cost cuts, with the manufacturers shutting down plants, reducing production, dropping product lines, and laying off workers. Chrysler took on two restructuring efforts by cutting 1.1 million vehicles and 26,000 workers (Welch, 2008). GM planned to reduce its manufacturing plants from 47 to 33. In addition, it entered into negotiations to sell its Saab brand and its transmission plant in France. It also planned to phase out its Saturn brand and cut 47,000 jobs (Vorman, 2009). Ford, which was losing money from its core car and truck business, decided to close five manufacturing plants including Cleveland Casting Plant and Maumee stamping plant and 35,000 jobs cuts (Schoenberger, 2011).

On the other hand, Toyota had maintained a TPS (Toyota Production System) operating system, grounded on a lean rather than traditional manufacturing system. In the face of the economic crisis, Toyota promptly adapted its production, whereby it perceived the economic crisis as an opportunity to develop human resources and thus work to establish a company with true strength and long-term stability. To this end, we will aim to eliminate waste and review the process and structure of every aspect of our operations (The Auto Channel, 2008). A key to the effectiveness of lean operations is to use freed capacity resulting from eliminating waste in the manufacturing processes. Waste involves any activity that does not add value to the customer but rather adds to the costs of production. Toyota believes that management efficiency lies in eliminating or reducing those non-value added activities, such as storing merchandise inventory, idle labour hours, machine breakdowns, and transportation costs from suppliers of parts and raw materials, while maintaining and improving products quality. By applying their lean strategy, Toyota achieved profits during the economic crisis: increasing growth in global operations through utilizing opportunities available in their product line-up (The Auto Channel, 2008). The gap between the cost of US cars and Japanese cars grew to $2,900 (Taylor, 2007). Toyota had implemented lean operations for decades with its customer-focused philosophy, just-in-time inventory system (pull system), and focus on eliminating waste. Their customer focus was a long-term strategy that assessed customers family planning and preferences (Key to Toyotas success). Accordingly, Toyota embarked on eco-cars long before the Big Three.

A tale of two auto plants'' illustrates the competitive advantage of Toyotas production system in San Antonio, Texas, where Toyota applied a system of waste reduction, continuous improvement, and just-in-time inventory (Hawkins & Shirouzu, 2006). Although both factories were located in the heart of TexasGM in Arlington and Toyota in San Antonioeach had a different structural and operational system. GMs factory had been in operation in Arlington for over 50 years, employing 3,000 workers. Despite renovation efforts in 2000, unlike Toyota, GM was bound by its long-term workers benefits, high wages, and layout constraints. It had to use long conveyors to transport its production from one process to the other, which consumed unnecessary throughput time. Older machinery meant more breakdowns and idle labour hours. Its suppliers were dispersed causing high transportation costs and potential for delivery delays.

Toyota, on the other hand, established its competitive advantage at its factory on lean operational and structural bases. The factory occupied one-third the space of GMs factory. It employed workers at $35/hour, less than half the hourly wage of GM workers. Its new machinery saved Toyota on maintenance and breakdown costs. The necessary parts to complete production were enclosed within each vehicle to save time and motion and prevent errors. In addition, Toyota was able to convince 21 of its suppliers to establish their factories around its San Antonio site (Hawkins & Nouhiko, n.d.).

Recent economy

In 2014, the Big Three auto manufacturers turned their losses into profits. Restructuring, government bailout, and union negotiations resulted in cost cuts. The labour force was cut and wages were controlled, plants were reduced, and unprofitable product lines dropped (AP Business Staff, 2011). According to Van Conway, a consultant and founder of the turnaround firm Conway MacKenzie. If all of us were to put ourselves back in 2009, could we imagine that GM could have done an IPO and these companies would be enjoying this level of profit? I don't think so (AP Business Staff, 2011). Ford was the only company to gain customers confidence by surviving without governmental interference (Navellier, 2014). Ford was leaner in its vision (Lool, 2010).

Since 2006, Ford has invested in the future to meet customers preferences. The company improved the quality of its products and invested in energy-saving electric and hybrid manufacturing plants (Lool, 2010). But it is still far from Toyotas lean. For example, to ensure quality and reduce cost, Toyota pull the cord, i.e., stops the production line 2,000 times/week to fix quality problems, while Ford averages only 2 times/week (Schifferes, 2007). But Toyota remained the world's biggest car manufacturer with a sales increase of 16% and profits up by 90% to $17.9 billion (Petroff & Yan, 2014).Approaches in Cost Accounting

Traditional costing system -

The primary purpose of accounting information, whether internal or external, is to provide management and investors with useful information to make sound decisions. When standard cost accounting was developed in the early 1900s, most companies cost structures consisted of 60% direct labour, 30% materials and 10% overhead (Kroll, 2004). Manufacturing cost structures included very little overhead, therefore companies allocated overhead costs to products in the same proportion as direct labour. It was volume driven. For example, consider when a company is producing two products, a standard and a customized product. Although the customized product might consume more overhead in terms of indirect material and supervision, the overhead would be allocated equally to both products based on the number of units produced. This would understate the unit cost of the customized product. Overhead was so insignificant that even if the allocation was incorrect, it wasnt a big deal (Kroll, 2004).

However, as machinery and processes in factories evolved, a new era of cost accounting arose. As manufacturers adjusted their approach to cost structures, they changed their cost accounting techniques and tools. Traditionally used tools such as standard cost of sales and variance adjustments on the income statement (Table 1), budgeting and performance reports, and variance analysis and responsibility centres. Accountants could no longer use the direct labour cost driver as the trigger for all indirect manufacturing costs. Determining and selecting an appropriate cost driver for indirect costs became a must. Cost accounting tools using multiple cost drivers were adopted. For example, utility expenses might be triggered by the number of machine hours and by the number of late-night shifts. Later, ABC (activity-based costing) techniques were developed and used.

Table 1: Traditional Income Statement.

Current Year Previous Year

Net Sales 240,000 216,000

Standard Cost of Sales 115,200 108,000

Material Price Variance -7,200 24,000

Material Usage Variance -4,800 12,000

Labour Efficiency Variance 16,800 -19,200

Labour Rate Variance -4,800 21,600

Overhead Volume Variance 4,800 4,800

Overhead Spending Variance -4,800 19,200

Overhead Efficiency Variance 38,400 -40,800

Total Cost of Sales 153,600 129,600

Gross Profit 86,400 86,400

Activity-based costing (ABC)

ABC techniques analyse organisational operations into activities such as order processing, design changes, and customer relations. By doing so, some indirect costs, which are allocated as product costs, become easily traceable to the identified activities. This reduces the allocation process, which in turn reduces allocation errors and improves product costing.

Chrysler claims that it saved hundreds of millions of dollars. ABC showed the true cost of certain parts Chrysler made was 30 times the original estimates, a discovery that persuaded the company to outsource the manufacture of many of those parts (The Economist, 2009).

Lean costing systems

Lean operations and accounting tools and techniques have gained popularity in recent years. The main focus in lean is waste and cost reduction. Grounded on value-added activities that customers are willing to pay for, Toyota Production System (TPS) is now synonymous with lean production. Such value-added activities include new vehicle design, costs of assembling and painting the vehicle, seatbelts, and airbags. Non-value-added activities are those additional costs incurred by the producer that do not increase the selling price. These are activities such as maintenance, floor clean up, and moving the material to the factory.

In lean operation and accounting, the company analyses the value stream: all activities from raw material purchases to conversion into finished product and customer delivery to identify and eliminate waste and improve operational effectiveness. Seven general wastes are identified in lean operations:

Over-production and early productionproducing over customer requirements, producing unnecessary materials/products; waitingtime delays, idle time (time during which value is not added to the product); transportationmultiple handling, delay in materials handling, unnecessary handling; inventoryholding or purchasing unnecessary raw materials, work in process, and finished goods; motionactions of people or equipment that do not add value to the product;

over-processingunnecessary steps or work elements/procedures

(non-value added work); and

defective unitsproduction of a part that is scrapped or requires rework (1000 Ventures, n.d.).

Traditional cost accounting tools shift to value formation analysis tools (Maskell & Baggaley, 2001). Traditional management accounting measurement systems focus on such issues as monthly variance reporting and earned hours, and are used for monitoring and judgment (Maskell & Baggaley, 2007). Instead, lean tools focus and push for continuous improvement. Each working cell is provided with a set of performance measures and clear guidance and empowerment for immediate action to fix any problem it might face such as pulling the cord. Clear and timely information for decision-making is provided rather than monthly. Its focus is on the costing the value stream rather than the product itself. This in turn encourages continuous improvement (Institute of Management Accountants, 2014).

Lean Accounting

Unlike traditional/standard costing, lean accounting provides financial information that focuses on the value stream; material inventory, processing costs, and occupancy costs (see Table 2). Thus it reveals savings and costs that might otherwise be misinterpreted or hidden (McKenna, 2011). The lean focus is on assessing continuous improvement and waste reduction, such as scrap and inventory.

According to Cunningham, with lean financial statements: Managers easily can see whether material use, scrap rates and labour costs for a product line are moving up or down. Inventory valuation also changes under lean accounting. Because of the focus on producing only to meet customer demand, inventories tend to be much lower than in traditional manufacturing operations. For instance, rather than including labour and overhead expenses in the cost of goods sold, a lean financial statement will show materials, labour and overhead as separate line items. That way the company will recognize labour and overhead expenses when it incurs them rather than having them get wrapped into inventory on the balance sheet. (Kroll, 2004)

Lean and traditional accounting tools

Income statementsComparative traditional income statements, issued for external compliance purposes, measure a companys profitability over a period of time. As a tool, the gross profit percentage is used to measure this progress over time. However, these financial statements fail to reveal certain operational improvements, such as waste reduction, because all manufacturing costs are grouped together and embedded within the cost of goods sold.

Lean income statements unveil the breakdown of the cost of goods sold; the material, labour, and overhead used, allowing companies to measure operational improvements.

Table 2: Lean Income Statement.

Current Year Previous Year

Net Sales 240,000 216,000

Cost of Sales: Purchase 84,720 59,760

Inventory Material: Increase/Decrease -6,000 6,000

Inventory Labour: Increase/Decrease 4,000 -4,000

Inventory Overhead: Increase/Decrease 2,000 -2,000

Overhead Volume Variance 4,800 4,800

Total Material Costs 84,720 59,760

Processing Costs: Total Cost of Sales 153,600 129,600

Gross Profit 86,400 86,400

Processing Costs: Factory Wages 26,400 27,600

Factory Salaries 5,040 4,800

Factory Benefits 16,800 12,000

Services and Supplies 5,280 6,000

Equipment and Depreciation 4,800 4,560

Scrap 4,800 9,600

Total Processing Costs 63,120 64,560

Occupancy Costs: Building Depreciation 480 480

Building Services 5,280 4,800

Total Occupancy Costs 5,720 5,280

Cost of Sales 153,600 129,600

Gross Profit 86,400 86,400

Production System: Push versus Pull

In traditional operations, manufacturers use cost-cutting strategies that encourage mass production. The fixed factory overhead such as factory rent, machinery depreciation, and insurance, is allocated equally over the units produced as part of the product cost. It becomes an expense on the income statement as the cost of sales only when the units produced are sold. So the larger the number of units produced relative to those sold, the lower fixed factory overhead included in the cost of sales, the higher the profits.

Table 3 illustrates two cases with the same fixed factory overhead and same unit sales. In case 1 the number of units produced (10,000) is half that of case 2 (20,000) which had a positive impact on the profitability of case 2, by reducing the cost of sales.

Table 3.Traditional Operations Promoting Mass Production.

Case 1: 10,000 units produced

Total Fixed Factory overhead (1) 100,000

Units Produced (2) 10,000

Cost/Unit = (1)/(2) = (3) 10

Units sold (4) 7,000

Fixed factory overhead included in the cost of sales = (3) X (4) 70,000

Case 2: 20,000 units produced

Total Fixed Factory overhead (1) 100,000

Units Produced (2) 20,000

Cost/Unit = (1)/(2) = (3) 5

Units sold (4) 7,000

Fixed factory overhead included in the cost of sales = (3) X (4) 35,000

The unsold units remain as inventory, which requires storage, and further push efforts in marketing and advertising to sell to customers. In addition, workers receive incentives for extra output productivity. However, lean strategies promote pull production and just-in-time inventory systems. Their manufacturing process is triggered by customer orders. That is, the manufacturer does not produce and stock up on merchandise unless there are customer orders. So the raw material is purchased according to manufacturing needs and all finished goods are delivered to customers.

Budgets and variance analysis

Traditional budgets and variance analysis tools also support a push production system. In a traditional cost accounting system, companies measure results against a budget. A formal budget is prepared a few months ahead of the fiscal year. The budgeted manufacturing costs: material, labour, and overhead are divided by the planned level of units of output, and a standard cost per unit is developed. The standard cost is applied to the units produced and eventually appears in the traditional income statement under the standard cost of sales, based on the units sold (see Table 1).

Actual costs of material, labour, and overhead vary from those budgeted. The difference between the budgeted and actual costs is considered an efficiency variance. For each of the three manufacturing inputs, the efficiency variance is further analysed into usage and price variance. The usage variance represents differences between budget and actual consumptions of units of material (material usage variance), labour hours (labour efficiency variance), or overhead driver units (overhead efficiency variance). The price variance represents differences between the budget and actual purchase price of the material (material price variance), hourly labour wage (labour rate variance), and overhead (overhead spending variance).

For example, the human resource department would justify the labour rate variance, while the factory supervisor would be responsible for all three inputs usage variances. Favourable variances support over-production and over-purchases, in line with mass-production strategies. Financial planning in lean organizations is more dynamic than is usual in traditional companies. The planning and budgeting process is done every month (typically) and is used to create an integrated game plan across the organization. The process is commonly called sales, operations, and financial planning (SOFP) (Institute of Management Accountants, 2014).Discussion Questions

1. The Big Three car manufacturers failed to sustain profitable operations during the 2008 economic crisis. Identify two major constraints in their traditional operational system that hindered adapting their production to the economic conditions. Explain and provide examples from the case and literature to support your answer. 30 marks. Word limit (max 1,100 words).

2. Toyota was able to sustain its profitable operations despite the economic crisis. List four advantages of its lean production system. Provide examples from the case and literature to support your answer. 40 marks. Word limit (max 1,400 words).

3. Use Table 1 to calculate the difference in the amount of gross profit over the two years and the gross profit margin for each year. Based on your analysis, briefly discuss which year is more profitable and why. 10 marks. Word limit (max 200 words).

4. Use Table 2 to prepare a vertical analysis by calculating the percentage of each component of cost of sales to net sales (two decimals). Based on your calculations, comment on the most significant components of the cost of sales and discuss the impact of traditional and lean costing tools on operations performance. 20 marks. Word limit (max 800 words).

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