Inventory Management, Just-in-Time, and Backflush Costing

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Inventory Management,Just-in-Time, andBackflush
Costing

• Chapter 20

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Learning Objective 1
Identify five categories of costs associated with
goods for sale.
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Costs Associated withGoods for Sale
1. Purchasing costs include transportation costs.
2. Ordering costs include receiving
and inspecting the items in the orders.
3. Carrying costs include the opportunity
cost of the investment tied up in inventory
and the costs associated with storage.
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Costs Associated withGoods for Sale
4. Stockout costs occur when an
organization runs out of a particular item for
which there is a customer demand.
5. Quality costs of a product or service is its
lack of conformance with a prespecified standard.
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Learning Objective 2
Balance ordering costs with carrying costs using
the economic-order-quantity (EOQ) decision model.
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Economic-Order-QuantityDecision Model Assumptions
1. The same quantity is ordered at each reorder
point.
2. Demand, ordering costs, carrying costs, and
purchase-order lead time are known with
certainty.
3. Purchasing costs per unit are unaffected by
the quantity ordered i.e. no discounts
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Economic-Order-QuantityDecision Model Assumptions
4. No stockouts occur.
5. Quality costs are considered only to
the extent that these costs affect
ordering costs or carrying costs.
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Economic-Order-QuantityDecision Model Assumptions
The EOQ minimizes the relevant ordering costs and
carrying costs.
Video store sells packages of blank video tapes.
Video purchases packages of video tapes
from Oaks, Inc., at 15/package.
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Economic-Order-QuantityDecision Model Assumptions
Annual demand is 12,844 packages, at the rate of
247 packages per week.
Video requires a 15 annual return on investment.
The purchase-order lead time is two weeks.
What is the economic-order-quantity?
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Economic-Order-QuantityDecision Model Assumptions
Relevant ordering cost per purchase order 209
Relevant carrying costs per package per
year Required annual ROI (15
15) 2.25 Relevant other costs
3.25 Total 5.50
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Economic-Order-Quantity Decision Model Example
EOQ
D Demand in units for a specified time period
P Relevant ordering costs per purchase order
C Relevant carrying costs of one unit in
stock for the time period used for D
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Economic-Order-Quantity Decision Model Example
EOQ
988 packages
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Economic-Order-Quantity Decision Model Example
What are the relevant total costs (RTC)?
RTC Annual relevant ordering costs Annual
relevant carrying costs
RTC
D Q

P

Q 2
C

DP Q

QC 2
or
Q can be any order quantity, not just the EOQ.
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Economic-Order-Quantity Decision Model Example
When Q 988 units,
RTC (12,844 209 988) (988 5.50 2)
5,434 total relevant costs
How many deliveries should occur each time period?
D EOQ
12,844 988


13 deliveries
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Economic-Order-Quantity Decision Model Example
10,000
8,000
Annual relevant total costs
Relevant Total Costs (Dollars)
6,000
5,434
Annual relevant ordering costs
4,000
Annual relevant carrying costs
2,000
600
1,200
1,800
988 EOQ
2,400
Order Quantity (Units)
20 - 15
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Reorder Point
Reorder point Number of units sold per unit of
time Purchase-order lead time
EOQ 988 packages Number of units sold/week
247 Purchase-order lead time 2 weeks
Reorder point 247 2 494 packages
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Reorder Point
988
Reorder Point
Reorder Point
494
Weeks
1
2
3
4
5
6
7
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Lead Time 2 weeks
Lead Time 2 weeks
This exhibit assumes that demand and
purchase-order lead time are certain Demand
247 tape packages/week Purchase-order lead
time 2 weeks
20 - 17
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Safety Stock Example
Safety stock is inventory held at all
times regardless of the quantity of
inventory ordered using the EOQ model.
Videos expected demand is 247 packages per week.
Management feels that a maximum demand of 350
packages per week may occur.
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Safety Stock Example
How much safety stock should be carried?
350 Maximum demand 247 Expected demand 103
Excess demand per week
103 packages 2 weeks lead time 206 packages
of safety stock.
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Considerations in ObtainingEstimates of Relevant
Costs
What are the relevant incremental costs of
carrying inventory?
only those costs of the purchasing company that
change with the quantity of inventory held
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Cost of Prediction Error
Predicting relevant costs requires care and is
difficult.
Assume that Videos relevant ordering cost is
97.84 instead of the 209 prediction used.
What is the cost of this prediction error?
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Cost of Prediction Error
Step 1 Compute the monetary outcome from the
best action that could have been taken, given the
actual amount of the cost input.
EOQ
EOQ
676 packages
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Cost of Prediction Error
The annual relevant total costs when EOQ is 676
packages is
RTC
DP Q

QC 2
RTC (12,844 97.84 676) (676 5.50
2) 3,718 total relevant costs
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Cost of Prediction Error
Step 2 Compute the monetary outcome from the
best action based on the incorrect amount of the
predicted cost input.
EOQ
988 packages
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Cost of Prediction Error
What are the annual relevant costs using this
order quantity when D 12,844 units, P 97.84,
and C 5.50?
RTC (12,844 97.84 988) (988 5.50
2) 3,989 total relevant costs
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Cost of Prediction Error
Step 3 Compute the difference between the
monetary outcomes from Steps 1 2.
Step 1 3,718 Step 2
3,989 Difference (271)
The cost of prediction error is 271.
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Learning Objective 3
Identify and reduce conflicts that can arise
between EOQ decision model and models used for
performance evaluation.
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Evaluating Managers andGoal-Congruence Issues
The opportunity cost of investment tied up in
inventory is a key input in the EOQ decision
model.
Some companies now include opportunity costs as
well as actual costs when evaluating managers.
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Just-In-Time Purchasing
Just-in-time (JIT) purchasing is the purchase of
goods or materials such that a delivery immediatel
y precedes demand or use.
Companies moving toward JIT purchasing argue that
the cost of carrying inventories (parameter C in
the EOQ model) has been dramatically
underestimated in the past.
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JIT Purchasing and EOQModel Parameters
The cost of placing a purchase order (parameter P
in the EOQ model) is also being re-evaluated.
Three factors are causing sizable reduction in
the cost of placing a purchase order (P).
1. Companies increasingly are establishing long-ru
n purchasing arrangements.
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JIT Purchasing and EOQModel Parameters
2. Companies are using electronic links, such as
the Internet, to place purchase orders.
3. Companies are increasing the use of purchase
order cards (similar to consumer credit cards
like Visa and Master Card).
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Learning Objective 4
Use a supply-chain approach to inventory
management.
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Supply-Chain Analysis
Supply-chain analysis describes the flow of
goods, services, and information from cradle to
grave, regardless of whether those activities
occur in the same organization or other
organizations.
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Learning Objective 5
Differentiate materials requirements planning
(MRP) systems from just-in-time (JIT) systems for
manufacturing.
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Materials RequirementPlanning (MRP)
Materials requirements planning (MRP) systems
take a push-through approach that manufactures
finished goods for inventory on the basis of
demand forecasts.
MRP predetermines the necessary outputs at each
stage of production.
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Materials RequirementPlanning (MRP)
Management accountants play key roles in an MRP
system, including...
maintaining accurate and timely
information pertaining to materials, work in
process, and finished goods, and...
providing estimates of the setup costs for
each production run, the downtime costs, and
carrying costs of inventory.
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Learning Objective 6
Identify the features of a just-in-time
production system.
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Just-In-Time Production Systems
Just-in-time (JIT) production systems take
a demand pull approach in which goods are only
manufactured to satisfy customer orders.
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Major Features of a JIT System
1. Organizing production in manufacturing cells
2. Hiring and retaining multi-skilled workers
3. Emphasizing total quality management
4. Reducing manufacturing lead time and setup time
5. Building strong supplier relationships
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Major Features of a JIT System
What information may management accountants use?
Personal observation by production line workers
and managers
Financial performance measures, such as inventory
turnover ratios
Nonfinancial performance measures of time,
inventory, and quality.
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Learning Objective 7
Use backflush costing.
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Backflush Costing
Backflush costing describes a costing system that
delays recording some or all of the journal
entries relating to the cycle from purchase of
direct materials to the sale of finished goods.
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Backflush Costing
Where journal entries for one or more stages in
the cycle are omitted, the journal entries for a
subsequent stage use normal or standard costs to
work backward to flush out the costs in the cycle
for which journal entries were not made.
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Learning Objective 8
Describe different ways backflush costing can
simplify traditional job-costing systems.
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Trigger Points
The term trigger point refers to a stage in a
cycle going from purchase of direct materials to
sale of finished goods at which journal entries
are made in the accounting system.
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Trigger Points
Stage A Purchase of direct materials
Stage B Production resulting in work in process
Stage C Completion of good units of product
Stage D Sale of finished goods
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Trigger Points
Assume trigger points A, C, and D.
This company would have two inventory accounts
Type 1. Combined materials and materials in
work in process inventory 2. Finished goods
Account Title 1. Inventory Raw and
In-process Control 2. Finished Goods Control
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Trigger Points
What is the journal entry when trigger point A
occurs?
Inventory Raw and In-process Control XX Accounts
Payable Control XX To record direct
material purchased during the period
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Trigger Points
What is the journal entry to record conversion
costs?
Conversion Costs Control XX Various
accounts XX To record the incurrence of
conversion costs during the accounting period
Underallocated or overallocated conversion
costs are written off to cost of goods sold.
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Trigger Points
What is the journal entry when trigger point C
occurs?
Finished Goods Control XX Inventory Raw
and In-Process Control XX Conversion
Costs Allocated XX To record the cost of
goods completed during the accounting period
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Trigger Points
What is the journal entry when trigger point D
occurs?
Cost of Goods Sold XX Finished Goods
Control XX To record the cost of goods sold
during the accounting period
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Trigger Points
Assume trigger points A and D.
This company would have one inventory account
Type Combines direct materials inventory and
any direct materials in work in process and
finished goods inventories
Account Title Inventory Control
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Trigger Points
What is the journal entry when trigger point A
occurs?
Inventory Raw and In-process Control
XX Accounts Payable Control XX To record
direct material purchased during the period
Same as the A, C, and D example.
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Trigger Points
What is the journal entry to record conversion
costs?
Conversion Costs Control XX Various
accounts XX To record the incurrence of
conversion costs during the accounting period
Same as the A, C, and D example.
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Trigger Points
What is the journal entry to record the cost of
goods completed during the accounting period
(trigger point C)?
No journal entry.
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Trigger Points
What is the journal entry when trigger point D
occurs?
Cost of Goods Sold XX Inventory
Control XX Conversion Costs
Allocated XX To record the cost of goods
sold during the accounting period
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End of Chapter 20