In this paper an effective two-phase approach adopting modified p-median mathematical model is proposed for grouping machines and parts in cellular manufacturing(CM). Unlike the conventional methods allowing machines and parts to be improperly assigned to cells and families, the proposed approach seeks to find the proper block diagonal solution where all the machines and parts are properly assigned to their most associated cells and families in term of the actual machine processing and part moves. Phase 1 uses the modified p-median formulation adopting new inter-machine similarity coefficient based on the non-binary production data-based part-machine incidence matrix(PMIM) that reflects both the operation sequences and production volumes for the parts to find machine cells. Phase 2 apollos iterative reassignment procedure to minimize inter-cell part moves and maximize within-cell machine utilization by reassigning improperly assigned machines and parts to their most associated cells and families. Computational experience with the data sets available on literature shows the proposed approach yields good-quality proper block diagonal solution.