Vipin 11172Anirban 111Surendra 111

BUSINESS ACCOUNTING AND FINANCE (II)

TERM PAPER

PROCESS COSTING IN JIT SYSTEMS

VIPIN PAVITHARAN(11172)ANIRBAN MAITHY(11201)SURENDRA(11205)PREM (11206)HARSHINI CHERUKU(11207)

Just In TimeJust In Time (JIT) is a production and inventory control system in which materials are

purchased and units are produced only as needed to meet actual customer demand. When Companies use Just in Time (JIT) manufacturing and inventory control system, they purchase materials and produce units only as needed to meet actual customers demand. In just in time manufacturing system inventories are reduced to the minimum and in some cases are zero. JIT approach can be used in both manufacturing and merchandising companies. It has the most profound effects, however, on the operations of manufacturing companies which maintain three class of inventories-raw material, Work in process, and finished goods. Traditionally, manufacturing companies have maintained large amounts of all three types of inventories to act as buffers so that operations can proceed smoothly even if there are unanticipated disruptions. Raw materials inventories provide insurance in case suppliers are late with deliveries. Work in process inventories are maintained in case a work station is unable to operate due to a breakdown or other reason. Finished goods inventories are maintained to accommodate unanticipated fluctuations in demand. While these inventories provide buffers against unforeseen events, they have a cost. In addition to the money tied up in the inventories, expert argue that the presence of inventories encourages inefficient and sloppy work, results in too many defects, and dramatically increase the amount of time required to complete a product.

Just-In-Time Concept:Under ideal conditions a company operating at JIT manufacturing system would purchase only enough materials each day to meet that days needs. Moreover, the company would have no goods still in process at the end of the day, and all goods completed during the day would have been shipped immediately to customers. "Just-In-Time" means that raw materials are received just in time to go into production, manufacturing parts are completed just in time to be assembled into products, and products are completed just in time to be shipped to customers.

Just-in-Time Inventory and Production ManagementAn important decision made by companies is the quantity of inventory maintained on hand for sale to customers. Significant trade-offs exist between maintaining excessive quantities of inventory and maintaining insufficient quantities of inventory. For example, at a grocery store, if insufficient quantities of inventory are on hand, the store will lose sales on those items and may lose the patronage of customers if stockouts are frequent. Conversely, maintaining larger quantities of inventory requires the grocery store to invest additional capital in those items, possibly resulting in insufficient capital to meet its other needs. Also, if inventory is perishable, the costs resulting from spoilage may become significant. In the current manufacturing environment, the large costs (insurance costs, storage costs, and cost of capital) associated with maintaining inventory have led to a movement away from stockpiling excessive quantities of inventory. A philosophy of inventory production that is consistent with this movement is referred to as just-in-time manufacturing (JIT). The JIT philosophy originated in Japan by Toyota and Kawasaki and is being increasingly used by U.S. manufacturing companies (such as Hewlett-Packard). The concept of JIT manufacturing is best shown by the description of Toyota’s manufacturing process

At Toyota, overproduction is considered one of the worst forms of waste. The company designs the work to flow from process to process without peaks or valleys and still arrive in just the right quantity for the customer.

Under JIT production, companies attempt to minimize the time period between the receipt of direct materials inventory to the delivery of inventory to customers; that is, inventory is produced “just in time” for delivery to customers. The major steps involved in this cycle are summarized below:

The following examples provide examples of the application of a just-in time philosophy:

Dell Computer makes its PCs to order, with the elapsed time from a customer’s phone call to loading the finished product onto a delivery truck generally equal to 36 hours. Customer orders are instantly relayed to one of Dell’s three plants (located in Austin, Texas; Penang, Malaysia; or Limerick, Ireland), where suppliers are expected to make component deliveries within an hour. Computer chips, boards, and drives are stored in trucks that are parked in bays just 50 feet from the beginning of the assembly line. Completed computers are immediately shipped to customers—Dell carries no finished goods inventory.

Netflix, an online DVD rental company, charges its subscribers $20 per month and allows them to make an unlimited number of rentals, so long as they have no more than three DVDs out at any one time. High demand levels created chaos in managing its DVD inventories, until Netflix came up with the ultimate just-in-time system. Customers return DVDs in preaddressed mailers. Immediately upon a DVD’s return, a Netflix employee scans the disc’s bar code, retrieves and prints a mailing label for the next subscriber on the waiting list for that DVD, and makes sure that the disc is sent out in the afternoon mail. The new system has reduced labor costs by about 15 percent, and the vast majority of DVDs never touch the shelf before they go out to the next viewer.

To illustrate the use of JIT manufacturing techniques, assume that The Indian Vegetable Company receives an order for 10,000 cans of its vegetable products to be delivered to the customer in 30 days. The Indian Vegetable Company has estimated the following time required for important events relating to this order:

• Lead time from ordering materials to receiving materials from vendors: four days.• Time required to complete production of 10,000 cans: one day (in both the Canning Department and Packaging Department.• Time required delivering inventory to customer: four days

Given the above information, The Indian Vegetable Company should order the materials in 21 days, as follows:

The same time constraints regarding the major manufacturing events are reflected in the above production schedule as in the JIT production schedule shown earlier. That is, a total of four days are still required from the date direct materials are ordered until they are received. In addition, four days are required to deliver the inventory to the organization’s customers. Recall that the JIT production schedule required only five days from receipt of the direct materials (day 25) until the finished products are delivered to customers (day 30). In contrast, the above production schedule requires a total of 26 days from receipt of the materials (day 4) until the delivery of finished products to customers (day 30). Where do the differences occur:

The above differences reflect the existence of non-value-added activities in the latter manufacturing process. Non-value-added activities are those activities that increase the length of time in the manufacturing/sales process without increasing the value of the product to the customer. Non-value added activities typically represent delays that occur in the manufacturing process from the time direct materials are received until the finished inventory is ready for sale to the organization’s customers. In the above example, the non-value-added activities include the time associated with inspection, transfer, waiting, and storage of direct materials, work-in-process, and finished goods inventory. The basic objective of JIT is to reduce the time spent by the organization on non-value-added activities.

The following example describes actions that companies have taken to eliminate non-value added activities and associated costs.

When Alexander Doll Company, maker of the coveted Madame Alexander doll, was on the brink of bankruptcy, TBM Consulting applied Toyota’s lean production techniques to bring it back to profitability. The doll-making process, where costumes can contain more than 20 separate pieces and must go through as many as 30 production steps, was originally organized as a batch manufacturing system. The result was an excessive work-in-process inventory and waiting periods for customers that could sometimes last as long as 16 weeks. TBM reorganized operations by creating seven- or eight-person teams that were responsible for completing approximately 300 doll or wardrobe assemblies per day. The result: work-in-process was cut by 96% and orders were filled in one to two weeks. IBM found that little changes in design and packaging can lead to enormous cost savings without decreasing customer value. When IBM replaced its four-color packaging box with a two-color blue-and-black box that costs 5 cents less, annual savings of $350,000 resulted. IBM engineers redesigned LCD monitors so that they would fit into smaller boxes, reducing shipping costs by $1.6 million.

In contrast, value-added activities represent those activities that increase the value of the product to the organization’s customers. In this example, the production times in the Canning and Packaging Departments are the sole value-added activities for The Indian Vegetable Company. JIT production systems reduce the levels of inventory maintained by the organization (and the non-value added activities described above) through some of the following methods or techniques.

1. Purchasing direct materials inventory in smaller quantities. By purchasing smaller quantities of direct materials inventory, the organization reduces the amount of these inventories maintained on hand. Ideally, materials should be purchased only as they are required to fill customer orders. If the organization maintains excessive direct materials inventory, it incurs greater levels of non-value-added costs in the form of storage costs and waiting time.In order to be successful, just-in-time or build-to-order companies must simplify the purchasing process. One approach to simplification is to reduce the number of different parts purchased; this is often accomplished by redesigning products so that one component part can be used in many different configurations. Lexmark International, a manufacturer of laser printers, cut the number of different fuses it stocks from 14 down to 4. Hoffman Enclosures, which makes large metal boxes for industrial supplies, purchases and stocks only one size of hinge and cuts it to length to suit a particular order.

International Truck & Engine Corporation pared down its purchasing and inventory costs by greatly reducing the complexity of its product line. While its current “medium” truck line has more than 800 combinations of engines and transmissions, the company is unveiling a new medium truck that has only 34 such combinations. What’s more, the company claims that each of the new combinations is superior because engineers took the time and effort to develop them in response to the needs of drivers.

2. Maintaining favorable relationships with suppliers and other vendors. If favorable relationships are maintained with suppliers and vendors, unanticipated shortages of direct materials inventory can be filled more easily.

3. Using a “pull” method of manufacturing. Under “pull” manufacturing, inventory in a given stage is produced only when required by the following manufacturing stage. For example, if The Indian Vegetable Company utilized a “pull” method of manufacturing, no inventory would be produced in the Canning Department until the production machinery was available for use in the Packaging Department. By using this manufacturing technique, the amount of work-in-process inventory maintained on hand is reduced.

The following example describes a form of “pull” manufacturing.

“Demand-flow manufacturing,” the brain child of John Costanza, founder of the John Costanza Institute of Technology, is a system of manufacturing that departs from the repetitive-processing approaches that have previously dominated Indian manufacturing. In demand-flow manufacturing, supplies of raw materials are replenished as necessary to meet changing customer demands for varied products. In addition, workers shift from one task to the next to avoid stockpiling of work-in process, and finished goods move directly from assembly lines to delivery trucks. Companies that have adopted the demand-flow methodology have been able to dramatically reduce the size of their finished goods inventory. They have, as a result, realized the benefits of decreased working capital requirements and increased inventory turnover rates

4. Establishing high quality standards for finished goods inventory.One important limitation of maintaining relatively small levels of inventories is that very little margin for error exists for substandard finished goods inventories. If substandard finished goods inventories exist, delays will occur as products must be reworked prior to their delivery to the customer. Thus, it is important that the organization establish high quality control standards to ensure high quality production.

5. Producing finished goods inventory in smaller quantities. Similar to direct materials inventories, finished goods inventories should be produced only as required for sale to the organization’s customers. As with direct materials inventories, maintaining excessive levels of finished goods inventory causes the organization to incur greater levels of non-value-added costs in the form of storage and waiting time. One limitation associated with JIT production is that it provides little room for unanticipated shutdowns or shortages in production. Three examples of this limitation are shown in the following recent excerpts from the business press.

General Motors Corp. (GM) fell short of its production goal of 90,000 cars and trucks because of problems at one of its engine plants. The production shortage was magnified by the shortage of existing automobile inventory created by GM’s decision to adopt a JIT inventory approach. However, Alan Dawes, executive in charge of operations at GM’s auto components group noted that “There’s no way we’re going away from just-in-time.”Boeing’s production process requires extensive cooperation between Boeing and its suppliers. In October 1997, late shipment of parts from Boeing’s suppliers did not permit workers to perform theirassembly tasks in the proper order. As a result, overhead costs soared to 30% of total labor costs and Boeing was forced to halt production at two of its facilities.

The January 1998 ice storms in eastern Canada were one of the worst natural disasters in that country’s history. These storms resulted in numerous power outages and delayed delivery of important materials components, significantly impacting manufacturing processes throughout Canada. Companies operating on a JIT process rented generators to reduce the disruption of their manufacturing processes. As the plant manager for Mitel Corp. (a manufacturer of semiconductor chips) noted, “we don’t produce to inventory; we produce to order only.”

The risks associated with a just-in-time inventory philosophy were highlighted in the wake of the September 11th terrorist attacks on New York City and Washington, D.C.

The grounding of air-freight carriers in response to the September 11th attacks had a significant disruptive effect on the U.S. manufacturing economy, which increasingly relies on just-in-time shipments. The resulting delivery interruptions, which translated into inventory stock-outs and production shutdowns, illustrate the risks of just-in-time methods, “where parts often arrive only hours before they’re needed, and a single missing part can shut down an assembly line.”

Heightened security at U.S. Customs checkpoints, as well as ports and airports, resulted in delays in transport and delivery of critical parts and components from abroad. While delays were inconvenient for all purchasers, companies with just-in-time purchasing practices were most severely impacted. A case in point: shortly after the attacks took place, inadequate supplies of component parts from Canada contributed to the closure of five of Ford’s U.S. manufacturing plants.

Four examples of the application of JIT production systems in practice follow below. Two of these systems appear to have been successful (Dell Computer and Oregon Cutting Systems); the other two were not (Allen- Edmonds and Bandai Co.). These examples illustrate one important point—despite their reported popularity in the business media, JIT production systems are not advantageous for all companies.

Dell Computer Corp., a computer retailer headquartered in Austin,Texas has taken the notion of justin- time manufacturing further by warehousing its component parts within fifteen minutes of a Dell factory and utilizing electronic commerce to receive customer payments. Unlike other manufacturers, Dell does not begin ordering component parts or assembling computers until an order is booked. Because the price of computer components may fall rapidly in just a few months, Dell’s component parts are newer (and cheaper) than those used in machines sold at the same time by its rivals. This can translate into a six-percent profit advantage in terms of the cost of component parts alone. This strategy puts pressure on suppliers to provide parts to Dell on a timely basis.

As a result of JIT, Oregon Cutting Systems, a manufacturer of cutting chains for chain saws, timber harvesting equipment, and sporting goods, realized the following benefits: (1) lead times for production were reduced from 21 days to 3 days; (2) productivity increased by 10 percent; (3) manufacturing costs were reduced by 35 percent; and (4) work-in-process and direct materials inventories were reduced by 50 percent.

Allen Edmonds Shoe Corp. is an example of a company whose experience with JIT production was not successful. Because it manufactures 41,000 varieties of shoes in limited production runs, Allen- Edmonds had to continually switch product lines under its JIT system, resulting in reduced levels of efficiency. In addition, the European tanneries supplying calfskin hides to Allen-Edmonds refused to provide their direct materials inputs on a demand basis, an important characteristic of JIT. In all, Allen-Edmonds estimates that its three-year experiment with JIT production resulted in a loss of $1 million.

An observation on the JIT inventory method which identifies its negative economic consequence:

The widespread adoption of just-in-time inventory techniques may have the unintended consequence of making economic recoveries more difficult. As more companies embrace a just-in-time inventory philosophy, the volatility of traditional economic indicators, such as capital goods orders, increases. This increased volatility makes the economy less predictable and reduces investor confidence, slowing the prospects for general recovery.

JIT CostingJIT costing may be used in conjunction with either a job-order or a process costing system. The distinguishing characteristic of JIT costing is that manufacturing costs are accumulated with inventory at later stages of the manufacturing process. The rationale for this difference is that JIT assumes that small or minimum (if any) quantities of direct materials, work-in-process, and finished goods inventories will be maintained by the organization. Since JIT assumes that the work-in-process and finished goods inventories maintained by the organization will be minimal, all manufacturing costs associated with production are normally accumulated directly in cost of goods sold in a JIT system. At the end of the period, the manufacturing costs associated with any unsold or uncompleted items are “backed out” and included in either finished goods inventory or work-in-process inventory, respectively, depending upon their status. For this reason, JIT costing is often referred to as “backflush” costing.

To illustrate the use of JIT costing, assume that Indian Vegetable uses JIT costing for the production of vegetables in its Canning Department during January 20x2. The following transactions summarize the major steps in Indian Vegetable’s production during the month of January (using the weighted-average method):

1. Total manufacturing costs incurred in January 20x2 in the Canning Department were $22,200. These costs consisted of $4,000 of direct materials costs, $10,400 of direct labor costs, and $7,800 of overhead costs. A total of $1,650 of costs were incurred in the Packaging Department, consisting of $330 of direct materials costs, $550 of direct labor costs, and $770 of manufacturing overhead costs.

2. Indian Vegetable’s inventories were as follows:

Under a JIT cost accumulation system, costs are accumulated as follows:• Since JIT systems operate under the assumption that minimal quantities of inventories are maintained, all inventory costs are transferred to cost of goods sold. Thus, at the beginning of January 20x2, the $7,120 of work-in-process inventory costs in the Canning Department are transferred to cost of goods sold.

• Similarly, all manufacturing costs are initially recorded in cost of goods sold instead of work-in-process inventory. Thus, the $22,200 of January manufacturing costs incurred in the Canning Department would be accumulated in cost of goods sold. Similarly, the $1,650 of January manufacturing costs incurred in the Packaging Department would also be directly recorded in cost of goods sold.

At this point, a total of $30,970 (beginning work-in-process costs of $1,120, current manufacturing costs of $22,200 in the Canning Department, and current manufacturing costs of $1,650 in the Packaging Department) has been accumulated in cost of goods sold. If no work-in-process or finished goods inventories existed at January 31, 20x2, this amount would properly reflect the total cost of goods sold to customers during January. However, based on the Production Cost Report, ending work-in-process inventory in the Canning Department is $4,020. In addition, The Indian Vegetable Company has ending finished goods inventories of $12,250.

• Once ending inventories have been determined, these costs are then “backed out” of cost of goods sold and transferred to work-in-process and finished goods inventory, respectively. This adjustment is the origin of the term “backflush” costing. Once these costs are transferred, a total of $14,700 ($30,970 – $4,020 – $12,250 = $14,700) remains in cost of goods sold. Recall that this represents the 6,000 cans of vegetables sold to customers at a cost of $2.45 per can .

Difficulties Encountered in Process Costing Procedures:Certain difficulties likely to be encountered in actual practice should be mentioned with regard to process cost accounting procedures:

1. The determination of production quantities and their stage of completion presents problem. Every computation is influenced by these figures. Since the data generally come to the cost department from operating personnel often working under circumstances that make a precise count difficult, a certain amount of double counts and unreliable estimates are bound to exist. Yet, the data submitted from the basis for the determination of inventory costs.

2. Materials cost computations frequently require careful analysis In the illustrations materials are generally considered to the the cost of first department. In certain industries, materials costs are not even entered on production reports. When materials prices are influenced by fluctuating market quotations, the materials cost may be recorded in a separate report designed to facilitate management decisions in relation to the materials market.

3. The discussion of lost units by shrinkage, spoilage, or evaporation indicates that the time when the loss occurs influences the final cost calculation. Different assumptions concerning the loss would result in departmental unit costs, which, in turn effect inventory costs, the cost of units transferred, and the completed unit cost. Another consideration involves the possibility of treating cost attributable to avoidable loss as an expense of the current period.

4. Industries using process cost procedures are generally of the multiple product type. Joint processing cost must be allocated the the products resulting from the processes. Weighted unit averages or other bases are used to prorate the joint cost to the several products. If units manufactured are used as a basis for cost allocation, Additional clerical expenses are necessary if the labor hour or machine hour basis is used for charging overhead to work in process. Management must decide whether economy and low operational cost are compatible with increased information based on additional cost computations and procedures.

ConclusionThe end results in a JIT cost accumulation system are identical to those illustrated for a conventional cost accumulation system. This raises the question of why the JIT cost accumulation system would be utilized in practice. If companies truly maintain minimal quantities of work-in-process and finished goods inventory, the JIT system does not require manufacturing costs to be accumulated with inventory as it is manufactured (work-in-process

inventory), transferred upon completion of the units (finished goods inventory), and then transferred as items are sold to customers (cost of goods sold). Instead, costs are initially recorded in cost of goods sold under the assumption that all items will be sold to customers as they are manufactured. Some companies use both process costing and job order costing procedures for various purposes in different departments. This is particularly true when a parallel or selective cost flow format is required. Each system or method employed by a company must be based on reliable production and performance data which, when combined with output, budget, or standard cost data, will provide the foundation for effective cost control and analysis.