Inventory Management

20 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster

Inventory Management,Just-in-Time, andBackflush Costing

Inventory Management,Just-in-Time, andBackflush Costing

Chapter 20


Learning Objective 1Learning Objective 1

Identify five categories of costs

associated with goods for sale.


Costs Associated withGoods for Sale


1. Purchasing costs include transportation costs.

2. Ordering costs include receiving andinspecting the items in the orders.

3. Carrying costs include the opportunity costof the investment tied up in inventory andthe costs associated with storage.




4. Stockout costs occur when an organizationruns out of a particular item for whichthere is a customer demand.

5. Quality costs of a product or service is its lackof conformance with a prespecified standard.



Balance ordering costs with

carrying costs using the

economic-order-quantity

(EOQ) decision model.


Economic-Order-QuantityDecision Model Assumptions


1. The same quantity is ordered at eachreorder point.

2. Demand, ordering costs, carrying costs,and purchase-order lead time areknown with certainty.

3. Purchasing costs per unit are unaffectedby the quantity ordered.




4. No stockouts occur.

5. Quality costs are considered only to theextent that these costs affect orderingcosts or carrying costs.




The EOQ minimizes the relevant orderingcosts and carrying costs.

Video store sells packages of blank video tapes.

Video purchases packages of video tapes fromOaks, Inc., at $15/package.




Annual demand is 12,844 packages, at therate 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?




Relevant ordering cost per purchase order: $209

Relevant carrying costs per package per year:Required annual ROI (15% × $15) $2.25Relevant other costs 3.25Total $5.50


Economic-Order-Quantity Decision Model ExampleEconomic-Order-Quantity Decision Model Example

EOQ =2DP

C

D = Demand in units for a specified time period

P = Relevant ordering costs per purchase orderC = Relevant carrying costs of one unit in stock for the time period used for D



2 12 84450

x x, $209$5.

976 144, = 988 packages

EOQ =



What are the relevant total costs (RTC)?

RTC = Annual relevant ordering costs+ Annual relevant carrying costs

RTC =

Q can be any order quantity, not just the EOQ.

DQ × P +

Q2 C×

DPQ +

QC2or



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?

DEOQ

12,844988= = 13 deliveries


20 - 15

Rel

evan

t Tot

al C

osts

(D

olla

rs)

2,000

4,000

6,000

8,000

10,000

5,434

600 1,200 1,800 2,400988EOQ

Annual relevant carrying costs

Annual relevant total costs

Annual relevant ordering costs

Order Quantity (Units)


Reorder PointReorder Point

Reorder point= Number of units sold per unit of time

× Purchase-order lead time

EOQ = 988 packagesNumber of units sold/week = 247

Purchase-order lead time = 2 weeks

Reorder point = 247 × 2 = 494 packages

Reorder PointReorder Point988

494

Weeks 1 2 3 4 5 6 7 8

Reorder Point

Reorder Point

This exhibit assumes that demand and purchase-order lead time are certain:

Demand = 247 tape packages/week Purchase-order lead time = 2 weeks20 - 17

Lead Time2 weeks

Lead Time2 weeks


Safety Stock ExampleSafety Stock Example

Safety stock is inventory held at all timesregardless of the quantity of inventory

ordered using the EOQ model.

Video’s expected demand is 247 packages per week.

Management feels that a maximum demand of350 packages per week may occur.


Safety Stock ExampleSafety 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.


Considerations in ObtainingEstimates of Relevant CostsConsiderations in ObtainingEstimates of Relevant Costs

What are the relevant incremental costsof carrying inventory?

– only those costs of the purchasing companythat change with the quantity of inventory held


Cost of Prediction ErrorCost of Prediction Error

Predicting relevant costs requires careand is difficult.

Assume that Video’s relevant ordering costis $97.84 instead of the $209 prediction used.

What is the cost of this prediction error?


Cost of Prediction Error

456 966,

EOQ =

EOQ =

Step 1: Compute the monetary outcomefrom the best action that could have been

taken, given the actual amount of the cost input.

2 12 844 97 84

50

x x, .

$5.

= 676 packages



The annual relevant total costs when EOQ is676 packages is:

RTC =DPQ

+QC2

RTC = (12,844 × $97.84 ÷ 676) + (676 × $5.50 ÷ 2)= $3,718 total relevant costs



Step 2: Compute the monetary outcomefrom the best action based on the incorrectamount of the predicted cost input.

EOQ =2 12 844

50x x, $209

$5.= 988 packages



What are the annual relevant costs usingthis 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



Step 3: Compute the difference betweenthe monetary outcomes from Steps 1 & 2.

Step 1 $3,718Step 2 3,989Difference $ (271)

The cost of prediction error is $271.



Identify and reduce conflicts

that can arise between EOQ

decision model and models used

for performance evaluation.


Evaluating Managers andGoal-Congruence IssuesEvaluating Managers andGoal-Congruence Issues

The opportunity cost of investment tied upin inventory is a key input in the

EOQ decision model.

Some companies now include opportunitycosts as well as actual costs when

evaluating managers.


Just-In-Time PurchasingJust-In-Time Purchasing

Just-in-time (JIT) purchasing is the purchaseof goods or materials such that a delivery

immediately precedes demand or use.

Companies moving toward JIT purchasingargue that the cost of carrying inventories(parameter C in the EOQ model) has beendramatically underestimated in the past.


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 reductionin the cost of placing a purchase order (P).

1. Companies increasingly are establishinglong-run purchasing arrangements.




2. Companies are using electronic links,such as the Internet, to place purchase orders.

3. Companies are increasing the use ofpurchase order cards (similar to consumercredit cards like Visa and Master Card).



Use a supply-chain approach

to inventory management.


Supply-Chain AnalysisSupply-Chain Analysis

Supply-chain analysis describes the flowof goods, services, and information from

cradle to grave, regardless of whetherthose activities occur in the same

organization or other organizations.

“bullwhip effect” or “whiplash effect”



Differentiate materials

requirements planning (MRP)

systems from just-in-time (JIT)

systems for manufacturing.


Materials RequirementPlanning (MRP)


Materials requirements planning (MRP)systems take a “push-through” approach

that manufactures finished goods forinventory on the basis of demand forecasts.

MRP predetermines the necessary outputsat each stage of production.




Management accountants play key roles inan MRP system, including...

– maintaining accurate and timely informationpertaining to materials, work in process,

and finished goods, and...

– providing estimates of the setup costs for eachproduction run, the downtime costs,

and carrying costs of inventory.



Identify the features of a

just-in-time production system.


Just-In-Time Production SystemsJust-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.


Major Features of a JIT SystemMajor 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


Major Features of a JIT SystemMajor Features of a JIT System

What information may management accountants use?

Personal observation by productionline workers and managers

Financial performance measures,such as inventory turnover ratios

Nonfinancial performance measuresof time, inventory, and quality.



Use backflush costing.


Backflush CostingBackflush Costing

Backflush costing describes a costingsystem that delays recording some orall of the journal entries relating to thecycle from purchase of direct materials

to the sale of finished goods.


Backflush CostingBackflush Costing

Where journal entries for one or more stagesin the cycle are omitted, the journal entries

for a subsequent stage use normal or standardcosts to work backward to flush out the costs in

the cycle for which journal entries were not made.



Describe different ways

backflush costing can simplify

traditional job-costing systems.


Trigger PointsTrigger Points

The term trigger point refers to a stage in a cyclegoing from purchase of direct materials to saleof finished goods at which journal entries are

made in the accounting system.



Stage A:Purchase of

direct materials

Stage B:Production resultingin work in process

Stage C:Completion of good

units of product

Stage D:Sale of

finished goods



Assume trigger points A, C, and D.

This company would have two inventory accounts:

Type1. Combined materials

and materials in workin process inventory

2. Finished goods

Account Title1. Inventory:

Raw and In-processControl

2. Finished Goods Control



What is the journal entry when trigger point A occurs?

Inventory: Raw and In-process Control XXAccounts Payable Control XX

To record direct material purchased during the period



What is the journal entry to record conversion costs?

Conversion Costs Control XXVarious accounts XX

To record the incurrence of conversion costs duringthe accounting period

Underallocated or overallocated conversion costsare written off to cost of goods sold.



What is the journal entry when trigger point C occurs?

Finished Goods Control XXInventory: Raw and In-Process Control XXConversion Costs Allocated XX

To record the cost of goods completed during theaccounting period



What is the journal entry when trigger point D occurs?

Cost of Goods Sold XXFinished Goods Control XX

To record the cost of goods sold during theaccounting period



Assume trigger points A and D.

This company would have one inventory account:

TypeCombines direct materialsinventory and any direct

materials in work in processand finished goods inventories

Account Title

Inventory Control



What is the journal entry when trigger point A occurs?

Inventory: Raw and In-process Control XXAccounts Payable Control XX

To record direct material purchased during the period

Same as the A, C, and D example.



What is the journal entry to record conversion costs?

Conversion Costs Control XXVarious accounts XX

To record the incurrence of conversion costs duringthe accounting period

Same as the A, C, and D example.



What is the journal entry to record thecost of goods completed during theaccounting period (trigger point C)?

No journal entry.



What is the journal entry when trigger point D occurs?

Cost of Goods Sold XXInventory Control XXConversion Costs Allocated XX

To record the cost of goods sold during theaccounting period


End of Chapter 20End of Chapter 20

Inventory Management

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