Electronic Process Equipment Tom Simon developed a process control system in the early 1980s for an inde- pendent pulp and paper mill on Vancouver Island. He had been hired as the shift engineer, but realized that many of the operational problems at the mill could be solved with improved process controls. Although he had not set out to develop a process control system, he developed numerous individual process controls before he understood that the integration of all process controls into a system would improve the mill's operational efficiency and effectiveness. After designing and implementing the world's first integrated process control system for a pulp and paper mill, he was promoted to chief engineer. However, that did not satisfy Simon's urge to be creative. In 1987, Simon, with two other young engineers, formed Electronic Process Equipment (EPE) to design, assemble, and implement process control systems for pulp and paper mills. Their first clients were British Columbia pulp and paper mills; then, after incorporating computers for better co-ordination, pro- cess control systems were sold to pulp and paper mills in Eastern Canada, to the states of Washington, Oregon, and Georgia, and to Norway. Subsequently, EPE expanded to all parts of the world where pulp and paper mills existed. By 1994, EPE was the world's leading process controls consulting engineering firm in the pulp and paper industry. The decision was made at that time to differen- tiate itself from all competitors by expanding into the research, development, and manufacture of leading-edge process control equipment. Then, in 1996, EPE expanded by providing process control systems to the petroleum and chemical industries. Presently, EPE is employee-owned and highly specialized in designing and manufacturing or assembling process control equipment for customers located around the world in the pulp, paper, petroleum, and chemical industries. EPE provides a full process control service, from the initial design to the detailed engineering drawings, to the manufacture or assembly of equipment, and to its installation, testing, and ongoing maintenance. EPE, as you would expect, has been dominated by engineers. All senior positions were occupied by engineers until 1999, when a chartered accountant was hired to be the vice-president finance. Since then there has been only one accountant among the engineers. Despite competition, EPE is now approachingCASE 20: ELECTRONIC PROCESS EQUIPMENT annual sales of half a billion dollars, but there have been concerns with the cost accounting system. As a consulting management accountant, you have been requested to evaluate the existing costing system and recommend changes in order that the needs of EPE be met. Your approach to the assignment is to (1) understand the existing system, (2) understand the needs for a cost account- ing system, (3) understand the shortcomings of the existing system with regard to the needs, and (4) recommend a cost accounting system that meets those needs. To understand the existing system, you meet with the vice-president finance, who (1) describes the system in general terms, (2) arranges inter- views for you with the controller, manager of cost accounting, and manager of budgeting, and (3) provides you with documentation of the existing system. With these sources you piece together descriptions of the existing cost account- ing system, needs, and shortcomings. Presently, there is a distributed accounting system that is provided by the same supplier that had been used with the earlier mainframe computer. This system is adequate for valuing inventory for financial reporting purposes and for preparing periodic financial reports. It has common data and account defi- nitions across different business units so that financial managers can readily compare and consolidate financial results across multiple units and divisions. Complete financial statements are issued shortly after the close of an account- ing period that require few, if any, post-closing adjustments. The statements are consistent with standards established by financial reporting, government, regula- tory, and tax authorities; the system of data recording and processing has excel- lent integrity so that it satisfies stringent audit and internal control standards. The existing system also reports individual product costs using variable and fixed cost classifications and responsibility centres used for external financial reporting, to value inventory and to measure cost-of-goods sold. The system provides financial feedback to managers and employees on the same reporting cycle used to prepare the aggregate organizational financial statements. The chart of accounts and database capacity allow a wide variety of special reports to be produced on the same basis as the financial reports. You interview all senior managers plus middle managers in cost account- ing, sales, and manufacturing. After 13 interviews, you conclude there is unani- mous agreement that the existing system is adequately meeting the requirement for financial reporting. Nevertheless, there are two shortcomings with the exist- ing system. First, the system is inadequate in estimating two areas: (i) the cost of activities and business processes; and (ii) the cost and profitability of prod- ucts, services, and customers. Second, the system is inadequate in providing use- ful feedback to improve processes. The first shortcoming arises from the assignment of costs to products and services. Direct labour hours are used to allocate indirect and support costs. Direct labour is not appropriate, because direct labour is not a high proportion of the company's manufacturing conversion costs. EPE has extensive automatic manufacturing processes. It also has shifted some of the costs of material acqui- sition activities (such as purchasing, receiving, inspection, handling, and storage) to a materials overhead pool; those costs are allocated to purchased items based on a percentage markup over purchase cost. To meet the needs of com- plex processes, multiple products and services, and diverse customers, EPE usesCASE 20: ELECTRONIC PROCESS EQUIPMENT additional allocation bases, like material cost and machine hours. These modifi- cations all assume that manufacturing indirect and support costs vary with the physical volume or number of the units manufactured. They fail to recognize that many expensive manufacturing resources are supplied to handle production of batches of items (activities required for set-up, ordering, receiving, moving. and inspecting products) and to design and sustain the myriad products the plant is capable of producing (activities required to design, improve, and main- tain individual products). The cost system fails to capture the economies of production batches and product variety. Another particularly devastating loss from the inaccurate cost system is that product designers and developers receive either no information or highly dis- torted information about the production costs of products they are designing. EPE's costing system forces product designers and developers to use obsolete and distorted information when making design choices and trade-offs. The crro- neous choices and trade-offs made during this phase become locked in; they are costly and difficult to change when the actual cost behaviour is revealed during the subsequent manufacturing phase. The cost system relies on responsibility cost centres for accumulating costs: both primary centres, where actual fabrication or assembly production work is performed, and secondary cost centres, such as indirect labour, maintenance, and tooling preparation, that provide services and support to the primary cost centres. However, assigning costs to responsibility centres gives little visibility to the costs of performing activities and business processes. Most activities and business processes use resources from many different cost centres. For example, it was noticed that an activity, like respond to customer requests, actually involved people from seven different departments. The customer service depart- ment, where the company thought this activity was focused, incurred only about 30 percent of the total cost of performing the total activity. The lack of infor- mation about the cost of activities and business processes has impeded EPPE in setting priorities for eliminating inefficiencies, and makes it essentially impossi- ble to benchmark activity and business process costs across units, either internal or external to the organization. Consequently, EPE often does not know where to focus total quality and re-engineering initiatives. The present cost accounting system allocates manufacturing costs to prod- ucts. However, the extensive costs for marketing, selling, administration, distri- bution, research and development, and general administration are not assigned at all to cost objects, such as products, services, and customers. This is because periodic financial reporting does not require or, in fact, allow these outlays to be assigned to cost objects. For financial reporting purposes, these cash expen- ditures are treated as period expenses. No attempt is made to causally link them to the activities and business processes actually being performed or to the cost objects - products, services and customers - that create the demand for or benefits from these expenditures. As there are no financial accounting requirements at all for allocating indi- rect and support expenses to services produced or customers served, the service part of EPE's business does not merely suffer from distorted cost numbers, it has no cost numbers at all. There are responsibility centres for services, but there is no understanding of the costs of individual services and the costs by customer.CASE 20: ELECTRONIC PROCESS EQUIPMENT The second shortcoming is that the existing system does not provide ade- quate information to support organizational continuous learning and improve- ment. The present competitive environment requires managers and operators to have timely and accurate information to help them make processes more effi- cient and more customer-focused. The existing system prepares and issues sum- mary financial feedback according to a monthly financial reporting cycle. Due to the complexities and adjustments associated with closing the books, the reports are delayed; though delayed only for several days after the close of the accounting period, it is still too late for responsibility centres to take immediate corrective actions. A production manager remarked: To understand the problem of delay and aggregated financial information, you could think of the responsibility centre manager as a bowler, throwing a ball at pins every minute. But we don't let the bowler see how many pins he has knocked down with each throw. At the end of the month we close the books, calculate the total number of pins knocked down during the month, compare this total with a standard, and report the total and the variance back to the bowler. If the total number is below standard, we ask the bowler for an explanation and encourage him to do better next period. We are beginning to understand that we won't turn out many world-class bowlers with this type of reporting system. In addition, the monthly performance reports for many operating depart- ments contain extensive cost allocations, forcing managers to be held account- able for performance that is neither under their control nor traceable to them. The costs of corporate or manufacturing-level resources, such as the heat and lighting in the building or the landscaping outside, are allocated arbitrarily to individual departments despite the departments having no responsibility for these costs. For example, referring back to the bowling metaphor, think about the accountants, after a ball is thrown down each of the establishment's 35 lanes, counting every pin knocked down, dividing by 35, and reporting back the average (say, 8.25714) to every bowler. The number may be quite accurate (it does represent the mean number of pins knocked down per alley), but it is completely useless to an individual bowler. Each bowler wants to know the number of pins he or she has knocked down in order to improve on the next throw. A number has no value when it is influenced by actions of others who are uncontrollable