Jit and Toc Essay

JIT benefits, as framed by Garrison and Noreen (2000), include the bolster of working capital by reducing capital in inventories; the optimization of space for more productive works; the increase of productivity; and the reduction of defect rates. Similarly, Younies, Barhem, and Hsu (2007) found that: The implementation of JIT can provide many advantages to a company. The usage of JIT techniques can improve a company’s problem solving capabilities by exposing problems in the production process as they occur. JIT reduces lead times and increases equipment utilization because of smaller lot sizes and delivery order sizes.

Product quality is increased because quality is centered on the individual workers, and the workers are considered part of the team. Input from workers is encouraged. Adoption of JIT usually reduces paper work, and requires only simple planning systems. A reduction in inventory is always achieved as the JIT philosophy aims to eliminate non-value-added time or wasted time. (p. 43) Though JIT system has many advantages, it is vulnerable to unexpected disruptions in supply. A production line can quickly come to a halt if essential parts are unavailable (Garrison and Noreen, 2000).

The authors used Toyota case as an example: “One Saturday, a fire at Aisin Seiki Company’s plant in Aichi Prefecture stopped the delivery of all brake parts to Toyota. By Tuesday, Toyota has to close down all of its Japanese assembly lines. By the time the supply of brake parts had been restored, Toyota had lost an estimated $15 billion in Sales. ” (p. 17) Younies, Barhem, and Hsu (2007) also pointed out some disadvantages associated with the implementation of JIT: “It may be difficult for JIT to be effective in certain types of environments.

JIT requires an atmosphere of close cooperation and mutual trust between the workforce and management. It is usually not as effective when labor is unionized. The use of JIT production or purchasing requires a large number of production setups and frequent shipments of purchased items from suppliers. Therefore, suppliers become very important and crucial to the company’s operations. The process is not well-suited for irregularly used parts or specially ordered products because it does not respond quickly to changes in schedules when there is little excess inventory available. (p. 43-44) With the above advantages and disadvantages, JIT is a critical factor in making managerial decision on inventories. In order to implement JIY effectively, the management should consider the capability and infrastructure level of the company. In addition, the restructuring costs to implement JIT versus the benefits from JIT should be taken into consideration. Another factor should be considered is the nature of the business since some materials/products are seasonal products which need to be built up to meet the production and market demands.

The Importance of TOC in making managerial decision on activity based accounting The Theory of Constraints (TOC) is a system’s management philosophy developed by Eliyahu M. Goldratt. In his book, called The Goal: A Process of Ongoing Improvement, Goldratt (1992) states that a firm’s goal is to make money now and in the future. A company will not exist if it is not making money. Any activity that does not help make money is a waste of time and resources. TOC emphasizes the importance of managing the organization’s constraints.

Since the constraint is whatever is holding back the organization, improvement efforts usually must be focused on the constraint in order to be really effective. TOC is implemented through three measures: throughput, operating expenses, and inventory. Throughput is the rate at which the system generates money through sales and as defined by Goldratt, throughput is revenue less direct materials. In order to increase the throughput, all bottlenecks of the system should be identified and the management should focus on improving the efficiency of the bottleneck which eventually improves the efficiency of the whole system.

The second measure of TOC is operating expenses which can be defined as all the money the system spends in order to turn the inventory into throughput. The cost of direct labor, raw materials, managers, machines, and material-handling activities are all included in this category. TOC argues that only the bottleneck must be kept busy all the time. All other operations should be either idle at some point during the production or be used to decrease the workload of the bottleneck of the system. The third concept in TOC is inventory which defined by Goldratt as “all the money the system invests in things it intends to sell. Since most of the managers believe that everything in the system should be kept busy at all time, there will exist an excess amount of inventory most of the time. This will decrease the performance of the system substantially because in this case the money of a company will be tied up in the inventory although it could be invested in a profitable project. In addition, excess inventory will mask the underlying problems of a company. So, to improve a system, the inventory level should be reduced gradually, and the problems revealed with the decreasing inventory level should be solved one by one.

Goldratt states that there is always at least one constraint that restricts the company’s ability to achieve its goal. When the system is improved such that it can produce as much as the demand, the active constraint will be an external constraint such as a lack of customer orders, logistical limitations, or availability of materials. TOC categorizes the resources into scarce bottleneck resources, non-bottleneck resources, and capacity constraint resources (CCR). A CCR is a resource that is not a bottleneck currently, but, if not managed properly, it could become a constraint.

Goldratt developed a five step process for managing constraints and improving the system continuously which include a) identify system constraints, b) exploit the system constraints, c) subordinate the decision, d) evaluate the system constraints, and e) if any steps has been broken, go back to step 1, but don’t allow inertia to cause a system constraint. This process can be used to increase throughput, while decreasing inventory and operating expenses. In this way the company will reach to its goal of making money.

Hence, the application of TOC in managerial decision making is very efficient, especially when the decision is made in conjunction with Activity Based Costing (ABC). ABC is a concept in which overhead is assigned to products based on the number of activities consumed by the products. It traces the cost of resources used in production to products. Gurses (1999) has studied the correlation between TOC and ABC in decision making process. He found that ABC is long-term oriented and under ABC, almost all of the costs are considered variable and changed according to the output level.

However, in the short run, there are many fixed costs such as the cost of labor, rent, equipment, etc and these costs are incurred within the company whether the product is produced or not. As a result, ABC may give wrong information about short-run decisions because of not reflecting the actual costs the company will incur in the short-run. In addition, ABC does not involve the constraints of a system into the analysis. In the short-run, the capacities of all the activities are fixed. But ABC omits this fact, and as a result, does not take into account the opportunity cost of using the ottleneck. ” (Gurses, 1999, p. 30) In the contrary, as pointed out by Gurses, TOC has a short-run time horizon and in the short-run, the capacity of a plant is fixed, and this fixed capacity will create the bottlenecks. However, in the long run, management can have an effect on capacity. Labor and overhead costs will not necessarily be fixed all the time. The weakness of TOC is that it does not include these costs and may give wrong information in the profitability analysis. The managers may decide to produce unprofitable products if they make decisions solely based on TOC. Gurses, 1999, p. 30) Since ABC and TOC are valid in different time horizons, they can complement each other. The weaknesses of one approach can be overcome by the strengths of the other approach, depending on the time horizon. Implementing these two concepts flexibility will enable managers make managerial decisions effectively. Cost Classifications In this part we will discuss the ways in which managers classify costs and study how the costs will be used- for preparing external reports, predicting cost behavior, assigning costs to cost objects, or decision making.

According to different purposes, costs can are classified in different ways which include the classification for purposes of reporting, predicting cost behavior, cost traceability, and making decisions. We will discuss further these classifications in the following part. Firstly, for the purpose of reporting or valuating inventories and determining expenses for the balance sheet and income statement, costs are classified as product costs and non-product costs or period costs. – Product costs or manufacturing costs are assigned to inventories and are considered assets until the products are sold.

Product costs are further subdivided into direct labor, direct material, variable overhead and fixed overhead which will be discussed below. Manufacturing costs are charged to work in process inventory as production occurs. When production is completed, the value of the goods completed is transferred to finished goods inventory. The value of completed production remains in finished goods inventory until the units are sold, at which time the value of the goods sold is transferred from finished goods inventory to cost of goods sold. The value of goods sold is thus expensed in the period of the sale. Non-manufacturing costs include administrative and selling expenses. In contrast to product costs, following the usual accrual practices, non-manufacturing costs or period costs are taken directly to the income statement as expenses in the period in which they are incurred. Non-manufacturing costs are never inventoried. Secondly, for the purpose of predicting cost behavior costs are classified into variable costs, and fixed costs. Cost behavior study how do costs fluctuate in response to changes in the volume of production inputs (e. g. , direct labor hours, board feet of lumber used) or production outputs (e. . , number of chairs produced)? Cost behavior is the sensitivity of costs to changes in production or sales volume. Variable costs, in total, are strictly proportional to activity. “Thus, the variable cost per unit is constant. Fixed costs, in total, remain at the same level for changes in activity that occurs within the level of activity. Thus, the average fixed cost per unit decreases as the number of units increases. ” (Garrison and Noreen, 2000, p. 62-63) – Variable costs vary in total with volume, but are constant per unit within the level of activity.

Total variable costs for a given situation are equal to the number of units multiplied by the variable cost per unit. Variable costs include things like labor and materials. Some overhead such as indirect labor, supplies and some utilities are also variable. – Fixed costs, in contrast, are constant in total over the level of activity. As production increases, total fixed costs stay the same within the level of activity, but since we are dividing a total fixed costs by a progressively larger denominator such as total production or sales, the resulting costs per unit become smaller and smaller.

Fixed costs include things like rent, insurance premiums, salaries, depreciation and property taxes. By classifying variable and fixed costs, we can figured out the relationship between revenues, costs, and production or sales volumes which are important elements in understanding the economics of a business. These relationships are typically referred to as cost volume profit relationships. Thirdly, for the purpose of traceability, costs are classified as direct or indirect. “Direct costs can be conveniently traced to the cost objects.

Indirect costs cannot be conveniently traced to cost objects. ” (Garrison and Noreen, 2000, p. 63) – Indirect costs are also known as overhead or burden. Indirect costs are those costs which cannot be specifically associated with a particular cost object. A cost object is any organizational or physical entity to which costs are assigned or charged. A cost object might be a completed unit of product, a subassembly, a department, a worker in the department, a product line, or en entire division of a larger corporation.

When we talk about manufacturing costs, the typical cost object is a unit of output. Selling and administrative expenses may also be traced to products, product lines, and organizational units. Such tracing may be useful in determining the relative profitability of the associated cost object such as products or division. Indirect costs (or overhead or burden) are also classified as fixed or variable as discussed above. – Direct cost is often used to assign costs to products and labor and material costs are typically treated as direct costs.

Direct labor is the touch labor directly associated with the actual production process, as opposed to those who support the production process. Following this reasoning, the wages of a worker who sets up a machine are an indirect cost, but the wages of the worker who actually runs the machine to make the product are a direct cost. Similarly, raw material or also called direct material is treated as a direct cost, although there are some exceptions. Some materials, such as spare parts, are too inexpensive to justify spending a lot of time tracking them.

Consequently, such items are often classified as indirect costs. Other indirect materials include lubricants, tools and supplies, sandpaper, rags, adhesives, and some finishing materials. For purposes of making decisions, the concept of differential costs and revenue, opportunity cost, and sunk cost are of vital importance. Differential cost and revenue are the cost and revenue items that differ between alternatives. Opportunity cost is the benefit that is forgone when one alternative is selected over another. Sunk cost is a cost that occurred in the past and cannot be altered.

Differential cost and opportunity cost should be careful considered in decisions. Sunk cost is always irrelevant in decisions and should be ignored. These various cost classifications are different ways of looking at costs. A particular cost, such as the cost of cheese in a taco served at Taco Bell, could be a manufacturing cost, a product cost, a variable cost, a direct cost, and a differential cost- all at the same time. Conclusions In today business environment, every managerial decision could affect the Company’s performance and is vital to the success of the company.

Various concepts- GAAP, JIT, TOC, and cost classifications, for instance- have been developed to facilitate managers making decisions. GAAP help the company to reduce fraud and misrepresentations of financial statements which enable both the investor and the management team have reliable information for decision making. JIT helps managers to utilize the available resources effectively and reduce the company’s wastes while TOC enable managers to maximize the potentials of the business by effectively manage the constraints.

Cost classifications facilitate the decision making process by providing insightful and relevant information for managers. In order to be successful in today challenging world, managers should continuously study and apply the above concepts in their daily works. On the other hand, it is critical for companies in provide sufficient trainings for their management team on these concepts in order to enable them to make efficient decisions for the business. Further studies on these concepts should be conducted to investigate application of these concepts in specific environment.