Controlling Inventory and Production Costs

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Chapter 11

• Controlling Inventory and Production Costs

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Learning Objectives

• 1. Why do managers use ABC inventory control
  systems?
• 2. How does a company determine from whom, how
  much, and when to order?

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Continuing . . . Learning Objectives

• 3. What are the differences between the economic
  order quantity model and materials requirements
  planning?
• 4. What is the JIT philosophy and how does it
  affect production?

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Continuing . . . Learning Objectives

• 5. What is the impact of flexible manufacturing
  systems on production and on satisfying
  customers?
• 6. How would the traditional accounting system
  change if a JIT inventory system were adopted?
  (Appendices 1 and 2)

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Continuing . . . Learning Objectives

• 7. How does the product life cycle influence
  sales and costs? (Appendix 3)

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Costs Associated with InventoryPurchasing or
Production
Purchasing
Production
Quoted price Direct material - Discounts
allowed Direct labor Shipping charges
Traceable overhead Insurance
charges Allocated fixed overhead while
items are in transit
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Costs Associated with InventoryOrdering or Setup
Ordering
Setup
Invoice preparation Labor time receipt
inspection Machine downtime Payment Forms
Clerical processing
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Costs Associated with InventoryCarrying or Not
Carrying (Stockout)
Not Carrying (Stockout)
Carrying
Storage Lost customer goodwill Handling Lost
contribution margin Insurance charges Ordering
shipping Property taxes charges from filling
Losses from obsolescence, special orders
damage, and theft Setup costs for
rescheduled Opportunity cost of production
invested capital
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Decisions in Purchasing Inventory

• In purchasing inventory, a purchasing manager
  needs to make three primary decisions.
• What supplier?
• What quantity?
• When to order?

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Traditional Supplier Relationship
Decision based primarily on price!
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Partnership Viewof New Buyer-Supplier Relations
Views cost in relation to quality and reliability
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Changes in Buyer-Supplier Relationship

• Number of vendors reduced to limited group
• Selected based on quality, reliability, price
• Quality certification
• Long-term contracts
• Develop better communications
• Site visits
• Assure quality and service
• Obtain quantity discounts
• Order size reduced
• Frequency of delivery increased
• Reduce operating costs

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Economic Order Quantity
AFTER the supplier is selected
?
2 Q O C
EOQ
Estimate of number of units per order that would
provide the optimal balance between ordering and
carrying costs
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Example

• Quantity needed per year (Q) 4,200 tons
• Cost of ordering (O) 30 per order
• Cost of carrying (C) 10 per ton
• Uses 15 tons of pulp wood per day
• Supplier can deliver in 3 days
• Maximum quantity used per day is 19 tons

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Economic Order Quantity
?
2 Q O C
EOQ
?
2 (4,200) 30 10
EOQ EOQ
159 (rounded)
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Total Inventory Costs

• Carrying Costs
• (159 ? 2) x 10 795
• Ordering Costs
• (4,200 ? 159) x 30 792
• Total Inventory Costs 1,587

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Questions to Ask Before Ordering

• Is storage space a limited resource?
• How critical is the item to production?
• How critical is cash flow?
• Can units be ordered in the quantity indicated?

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When to Order
Safety Stock (Maximum Usage - Normal Usage) x
Lead Time ( 19 - 15) x 3
12 tons Order Point (Daily Usage x Lead Time)
Safety Stock ( 15 x 3)
12 57 tons
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Problems with EOQ Model

• Is difficult to identify all relevant inventory
  costs
• Does not provide any direction for managers
  attempting to control individual types of
  purchasing and carrying costs
• Ignores relationships among inventory items

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Materials Requirements Planning
Answers the questions

• What items are needed?
• How many of them are needed?
• When are they needed?

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Steps in an MRP System

• Sales forecast used to develop a master
  production schedule (MPS)
• Computer MRP model generates a time-sequenced
  schedule for purchases and production component
  needs using
• Product bill of materials and operations flow
  document
• Inventory balances
• Lead time

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Continuing . . . Steps in an MRP System

• Work load compared with capacity bottlenecks
  identified
• MRP program run again until all bottlenecks
  accounted for

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MRP IIManufacturing Resource Planning
Plans production jobs using MRP AND calculates
resource needs such as labor and machine hours
Involves manufacturing, marketing, and finance
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Push System
WIP Storage
Purchases
WIP Storage
Work Center
FG Storage
Work Center
Work Center
Materials Storage
Sales
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Just-In-Time Systems
Three primary goals

• Eliminating any production process or operation
  that does not add value to the product/service
• Continuously improving production/ performance
  efficiency
• Reducing the total cost of production/ performance
  while increasing quality

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Elements of JIT Philosophy

• Eliminate as much inventory and storage space as
  possible
• Keep lead time short by using frequent deliveries
• Use creative thinking to find ways to reduce
  costs
• Work to eliminate defects and scrap

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Continuing . . . Elements ofJIT Philosophy

• Establish good relationships with suppliers
• Listen to employees
• Train employees to be multiskilled and increase
  productivity
• Constantly look for ways to improve operations

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Pull System
Work Center
Purchases
Work Center
Work Center
Sales
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Product Processing

• Reduce machine setup time
• New equipment
• Training
• Implement highest quality standards and focus on
  goal of zero defects
• Quality determined on continuous basis
• Vendor product quality
• Quality in conversion process
• Modern production equipment

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Traditional Manufacturing Plant Layout
WIP
WIP
WIP
F i n i s h e d
M
G o o d s
a t e r i a l s
WIP
WIP
WIP
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Just-In-Time Manufacturing Plant Layout
F i n i s h e d
G o o d s
M
a t e r i a l s
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Employee Empowerment

• Put the right people in the right jobs
• Make training an ongoing process
• Provide employees with necessary tools
• Equipment
• Information
• Authority
• Training
• Push decision-making authority and responsibility
  down to lowest reasonable level
• Establish atmosphere of trust among all employees
  at all levels

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Seven Steps to Implement a JIT System

• 1. Determine how well products, materials, or
  services are delivered now.
• 2. Determine how customers define superior
  service, and set priorities accordingly.
• 3. Establish specific priorities for distribution
  (and possibly purchasing) functions to meet
  customer needs.
• 4. Collaborate with and educate managers and
  employees to refine objectives and to prepare for
  implementation of JIT.

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Continuing . . . Seven Steps to Implement a JIT
System

• 5. Execute a pilot implementation project and
  evaluate its results.
• 6. Refine the JIT delivery program and execute it
  company wide.
• 7. Monitor progress, adjust objectives over time,
  and always strive for excellence.

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Important Relationships

• Every company has a set of upstream suppliers
  and a set of downstream customers. In a
  one-on-one context, these parties can be depicted
  in the following model

Upstream Supplier
The Company
Downstream Customer
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Continuing . . . Important Relationships

• Consider the following opportunities for
  improvement between entities
• improved communication of requirements and
  specifications
• greater clarity in requests for products or
  services
• improved feedback regarding unsatisfactory
  products or services
• improvements in planning, controlling, and
  problem solving
• shared managerial and technical expertise,
  supervision, and training

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Flexible Manufacturing Systems

• A flexible manufacturing system (FMS) is a
  network of robots and material conveyance devices
  monitored and controlled by computers.
• Two or more FMSs connected by a host computer
  and an information networking system are
  generally referred to as computer integrated
  manufacturing (CIM).

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Comparison of Traditional Manufacturing and FMS
TRADITIONAL
FACTOR MANUFACTURING FMS

• Information requirements Batch-based On-line,
  real-time
• Product variety Low Basically unlimited
• Response time to market needs Slow Rapid
• Worker tasks Specialized Diverse
• Production runs Long Short
• Lot sizes Massive Small

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Continuing . . . Comparison of Traditional
Manufacturing and FMS
TRADITIONAL
FACTOR MANUFACTURING FMS

• Basis of performance rewards Individual Team
• Setups Slow and expensive Fast and inexpensive
• Product life cycle expectation Long Short
• Work area control Centralized Decentralized
• Technology Labor-intensive Technology-
  intensive
• Worker knowledge of technology Low to
  medium Highly trained

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Accounting Implications of JIT

• End-of-period variance reporting and analysis
  essentially disappears
• Variances recognized on the spot
• Two comparison standards annual and current
• Use conversion costs rather than labor and
  overhead
• Inventory accounting
• Raw and In Process (RIP) Inventory account

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Backflush Costing

• Streamlined cost accounting method that speeds
  up, simplifies, and reduces accounting effort
• During period, records purchases of materials and
  accumulates conversion costs
• At completion or sale, total costs incurred
  recorded to cost of goods sold and finished goods
  inventory using standard production costs

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Continuing . . . Backflush Costing

• Bernard Companys standard production cost per
  unit
• Direct material 75
• Conversion 184
• Total costs 259
• No beginning inventories exist.

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Continuing . . . Backflush Costing

• (1)
• Raw and In Process Inventory 1,530,000
• Accounts Payable 1,530,000
• Purchased 1,530,000 of direct materials in June.

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Continuing . . . Backflush Costing

• (2)
• Conversion Costs 3,687,000
• Various accounts 3,687,000
• Incurred 3,687,000 of conversion costs in June.

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Continuing . . . Backflush Costing

• (3)
• Finished Goods Inventory 5,180,000
• Raw and In Process Inventory 1,500,000
• Conversion Costs 3,680,000
• Completed 20,000 units of production in June.

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Continuing . . . Backflush Costing

• (4)
• Cost of Goods Sold 5,128,200
• Finished Goods Inventory 5,128,200
• Accounts Receivable 8,316,000
• Sales 8,316,000
• Sold 19,800 units having a cost of 259 per unit
  on account in June for 420.

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Continuing . . . Backflush Costing

• Ending Inventories
• Raw and In Process (1,530,000 -
  1,500,000) 30,000
• Finished Goods (5,180,000 - 5,128,200)
  51,800
• In addition, there are underapplied conversion
  costs of 7,000 (3,687,000 - 3,680,000).