CHAPTER 20

1. CHAPTER 20 Inventory Management, Just-in-Time, and Simplified Costing Methods

2. Chapter 20 learning objectives • Identify six categories of costs associated with goods for sale • Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model • Identify the effect of errors that can arise when using the EOQ decision model and ways to reduce conflicts between the EOQ model and models used for performance evaluation

3. Chapter 20 learning objectives, cont’d • Describe why companies are using just-in-time (JIT) purchasing • Distinguish materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing • Identify the features and benefits of a just-in-time production system

4. Chapter 20 learning objectives, concluded • Describe different ways backflush costing can simplify traditional inventory-costing systems • Understand the principles of lean accounting

5. Inventory Management in Organizations • Inventory management includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization.

6. Costs Associated with Goods for Sale, overview • Managing inventories to increase net income requires effectively managing costs that fall into these six categories: • Purchasing costs. • Ordering costs. • Carrying costs. • Stockout costs. • Quality costs. • Shrinkage costs.

7. Costs Associated with Goods for Sale, details • Purchasing costs—the cost of goods acquired from suppliers, including incoming freight costs. Usually this is the largest cost category of goods in inventory. • Ordering costs—the costs of preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments.

8. Costs Associated with Goods for Sale, details, cont’d • Carrying costs—the costs that arise while goods are being held in inventory. These costs include the opportunity cost of the investment tied up in inventory, and costs associated with storage. • Stockout costs—the costs that arise when a company runs out of a particular item for which there is customer demand (stockout). The company must act quickly to meet the demand or suffer the costs of not meeting it.

9. Costs Associated with Goods for Sale, details, concluded • Costs of Quality – the costs incurred to prevent and appraise, or the costs arising as a result of, quality issues. Recall from chapter 19, there are four categories of quality costs: • Prevention. • Appraisal. • Internal failure. • External failure. • Shrinkage costs—costs that result from theft by outsiders, embezzlement by employees, misclassifications and clerical errors. Shrinkage is measured by the difference between the cost of inventory on the books vs the cost of the physical count.

10. The First Step in Managing Goods for Sale: the economic order quantity • The first decision in managing goods for sale is how much to order of a given product. • Economic order quality (EOQ) is a decision model that calculates the optimal quantity of inventory to order under a given set of assumptions.

11. Basic EOQ Assumptions • There are only ordering and carrying costs. • The same quantity is ordered at each reorder point. • Demand, purchase-order lead time, ordering costs, and carrying costs are known with certainty. • Purchasing costs per unit are unaffected by the quantity ordered. (Therefore, purchasing costs are irrelevant.) • No stockouts occur. • Managers consider the costs of quality and shrinkage costs only to the extent that these costs affect ordering or carrying costs.

12. EOQ Formula-results in the quantity that minimizes annual relevant total costs D = Demand in units for specified period P = Relevant ordering costs per purchase order C = Relevant carrying costs of one unit in stock for the time period used for D

13. Ordering and Carrying Costs Illustrated

14. When to order (assumes certainty of demand and lead time) • The second decision in managing goods for sale is when to order a given product. • Reorder point—the quantity level of inventory on hand that triggers a new purchase order.

15. Ordering Points Illustrated

16. Safety Stock (demand and lead time uncertain) • Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. • Safety stock is a buffer against unexpected increases in demand, uncertainty about lead time, and unavailability of stock from suppliers. • Managers use a frequency distribution based on prior daily or weekly levels of demand to compute safety-stock levels.

17. Estimating Inventory-Related Relevant Costs and their effects The relevant costs are categorized as follows: • Carrying costs – see next slide • Stockout costs – the cost of expediting an order from a supplier • Ordering costs – those ordering costs that change with the number of orders placed

18. Carrying Costs • Relevant inventory carrying costs consist of relevant incremental costs and the relevant opportunity cost of capital. • Relevant incremental costs—those costs of the purchasing firm that change with the quantity of inventory held.

19. Opportunity Costs • Relevant opportunity cost of capital—the return foregone by investing capital in inventory rather than elsewhere. • It is calculated as the required rate of return multiplied by the per-unit costs of acquiring inventory, such as the purchase price of units, incoming freight, and incoming inspection. • Opportunity costs are also computed on investments if these investments are affected by changes in inventory levels.

20. Cost of a Prediction Error • Three steps in determining the cost of a prediction error: • Compute the monetary outcome from the best action that could be taken, given the actual amount of the cost per purchase order. • Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost per purchase order. • Compute the difference between steps 1 and 2.

21. Just-in-Time Purchasing • Just-in-time (JIT) purchasing, a method of managing purchases so the materials or goods are delivered just as needed for production or sales. • JIT purchasing is not guided solely by the EOQ model because that model only emphasizes the tradeoff between relevant carrying and ordering costs.

22. JIT Purchasing, concluded • JIT reduces the cost of placing a purchase order because: • Long-term purchasing agreements define price and quality terms. Individual purchase orders covered by those agreements require no additional negotiation regarding price or quality. • Companies are using electronic links to place purchase orders at a small fraction of traditional methods (phone or mail). • Companies are using purchase-order cards (similar to consumer credit cards).

23. Relevant Costs in JIT Purchasing Relevant costs for the EOQ model are the carrying and ordering costs. Inventory management includes purchasing costs, stockout costs, costs of quality and shrinkage costs. JIT relevant costs include: • Purchasing costs • Ordering costs • Opportunity costs • Carrying costs • Stockout costs • Quality costs

24. JIT Purchasing and Supply-Chain Analysis • Supply chain describes the flow of goods, services, and information from the initial sources of materials and services to the delivery of products to consumers. • Supply chain members share information and plan/coordinate activities. • Supplier evaluations are critical to JIT purchasing implementation.

25. Inventory Management, Materials Requirements Planning (mrp) & jit production • Materials requirements planning (MRP)—a “push-through” system that manufactures finished goods for inventory on the basis of demand forecasts. • JIT production is a “demand-pull” approach and is also called lean production. Each component in a production line is produced as soon as, and only when, needed by the next step in the production line.

26. MRP Information Inputs • To determine outputs at each stage of production, MRP uses: • The demand forecasts for final products. • A bill of materials detailing the materials, components, and subassemblies for each final product. • Information about a company’s inventories of materials, components, and products.

27. MRP, process • Taking into account the lead time required to purchase materials and to manufacture components and finished products, a master production schedule specifies the quantity and timing of each item to be produced. • Once production starts as scheduled, the output of each department is pushed through the production line. • Maintaining accurate inventory records and costs is critical in an MRP system.

28. Inventory Management, MRP and JIT Production • JIT (lean) production is a “demand-pull” manufacturing system that manufactures each component in a production line as soon as, and only when, needed by the next step in the production line. • Demand triggers each step of the production process, starting with customer demand for a finished product and working all the way back to the demand for direct materials at the beginning of the process.

29. JIT Production Goals • JIT production systems result in close coordination among work-stations. • Smooths the flow of goods. • Achieves low quantities of inventory. • JIT aims to simultaneously: • Meet customer demand in a timely manner. • Produce high quality products. • Generate the lowest possible costs.

30. Features of JIT Production systems • Production is organized in manufacturing cells, which are work areas with different types of equipment grouped together to make related products. • Workers are hired and trained to be multi-skilled (cross-trained). • Defects are aggressively eliminated. • Setup time and manufacturing cycle time are reduced. • Suppliers are selected on the basis of their ability to deliver quality materials in a timely manner.

31. Costs and Benefits of JIT Production • Lower overhead costs • Lower inventory levels, lower carrying costs • Heightened emphasis on improving quality by eliminating the specific causes of rework, scrap, and waste • Lower manufacturing cycle times

32. Enterprise Resource Planning (ERP) Systems ERP systems are frequently used in conjunction with JIT production. • An ERP system is an integrated set of software modules covering a company’s accounting, distribution, manufacturing, purchasing, human resources and other functions. • Real-time information is collected in a single database and simultaneously fed into all of the software applications, giving personnel greater visibility into the company’s end-to-end business processes. • Companies believe that an ERP system is essential to support JIT initiatives because of the effect it has on lead time.

33. Enterprise Resource Planning (ERP) Systems, concluded • The challenge, when implementing ERP systems, is to strike the proper balance between the lower cost and reliability of standardized systems and the strategic benefits that accrue from customization.

34. Performance Measures and Control in JIT • Financial performance measures such as inventory turnover ratio, which is expected to increase. • Nonfinancial performance measures of time, inventory, and quality such as: • Number of days of inventory on hand: expected to decrease. • Units produced per hour: expected to increase • % of scrapped/rework over total units started: expected to decrease. • Manufacturing cycle time: expected to decrease. • Setup time: expected to decrease.

35. Backflush Costing Traditional normal or standard-costing systems use sequential tracking in which the recording of the journal entries occurs in the same order as actual purchases and progress in production. As a reminder, the 4 stages are: Purchase of Direct Materials & Incurring of Conversion costs* Production resulting in WIP Completion of Good finished units of product* Sales of finished goods* * Indicates a trigger point for journal entries

36. Backflush Costing, cont’d • Backflush costing omits recording some of the journal entries relating to the stages from the purchase of direct materials to the sale of finished goods. • Because some stages 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.

37. Backflush Costing, concluded • Backflush costing does not necessarily comply with GAAP. • However, inventory levels may be immaterial, negating the necessity for compliance. • Backflush costing does not leave a good audit trail—the ability of the accounting system to pinpoint the uses of resources at each step of the production process.

38. Lean Accounting • Another simplified product costing system that can be used with JIT systems is lean accounting. • When a company utilizes JIT production, it has to focus on the entire value chain of business functions in order to reduce inventories, lead times and waste. • The improvements that result have led some companies with JIT systems to develop organizations structures and costing systems that focus on value streams.

39. Lean accounting and Value streams • Value streams are all the value-added activities needed to design, manufacture, and deliver a given product or product line to customers. • Lean accounting is a costing method that focuses on value streams, as distinguished from individual products or departments, thereby eliminating waste in the accounting process. • Tracing more costs as direct costs to value streams is possible because companies using lean accounting often dedicate resources to individual value streams.

40. Lean accounting and value streams, concluded • Lean accounting is much simpler than traditional product costing because calculating actual product costs by value streams requires less overhead allocation. • Critics of lean accounting charge that it does not compute the costs of individual products, which makes it less useful for making decisions. • Critics of lean accounting charge that it excludes certain support costs and unused capacity costs. • A final criticism is that, like backflush costing, it does not correctly account for inventories under GAAP.

41. Terms to learn

42. Terms to learn