Cost 20

Inventory Management, Just-in-Time, and Backflush Costing Chapter 20 20 - 1

Introduction Inventory management is a pivotal part of profit planning for manufacturing and merchandising companies. ■ Accounting information can play a key role in inventory management. ■

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Learning Objectives 1 2

3

Identify five categories of costs associated with goods for sale Balance ordering costs and carrying costs using the economic-order-quantity (EOQ) decision model Identify and reduce conflicts that can arise between EOQ decision models and models used for performance evaluation 20 - 3

Learning Objectives 4 5

Use a supply-chain approach to inventory management Differentiate materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing

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Learning Objectives 6 7 8

Identify the major features of a just-in-time production system Use backflush costing Describe different ways backflush costing can simplify traditional job-costing systems

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Learning Objective 1 Identify five categories of costs associated with goods for sale

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Costs Associated with Goods for Sale ■ 1 2 3 4 5

Five categories of costs associated with goods for sale are: Purchasing costs Ordering costs Carrying costs Stockout costs Quality costs 20 - 7

Purchasing Costs Purchasing costs are the costs of goods acquired from suppliers including incoming freight or transportation costs. ■ These costs usually make up the largest single cost category of goods for sale. ■ Discounts for different purchase-order sizes and supplier credit terms affect purchasing costs. ■

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Ordering Costs Ordering costs are the costs of preparing, issuing, and paying purchase orders, plus receiving and inspecting the items included in the orders. ■ Purchase approval and special processing costs are related to the number of purchase orders processed. ■

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Carrying Costs Carrying costs arise when an organization holds an inventory of goods for sale. ■ These costs include the opportunity cost of the investment tied up in inventory and the costs associated with storage such as space rental, insurance, obsolescence, and spoilage. ■

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Stockout Costs A stockout cost occurs when an organization runs out of a particular item for which there is a customer demand. ■ Expediting costs of a stockout include: – Additional ordering costs – Associated transportation costs ■

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Stockout Costs ■ – –

Opportunity cost of a stockout includes: Lost contribution margin on the sale not made Any contribution margin lost on future sales hurt by customer ill-will caused by the stockout.

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Quality Costs Quality costs of a product or service is its lack of conformance with a preannounced or prespecified standard. ■ There are four categories of costs of quality: 1 Prevention costs 2 Appraisal costs 3 Internal failure costs 4 External failure costs ■

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Learning Objective 2 Balance ordering costs and carrying costs using the economic-order-quantity (EOQ) decision model

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Economic-Order-Quantity Decision Model The economic-order-quantity (EOQ) is a decision model that calculates the optimal quantity of inventory to order under a restrictive set of assumptions. ■ The simplest version of this model incorporates only ordering costs and carrying costs into the calculations. ■

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Economic-Order-Quantity Decision Model ■ 1 2 3

Assumptions: The same fixed quantity is ordered at each reorder point. Demand, ordering costs, and carrying costs are known with certainty. Purchase-order lead time – the time between placing of an order and its delivery – is also known with certainty. 20 - 16

Economic-Order-Quantity Decision Model 4 5

6

Purchasing costs per unit are unaffected by the quantity ordered. No stockouts occur. One justification for this assumption is that the costs of a stockout can be prohibitively high. In deciding the size of the purchase order, managers consider the costs of quality only to the extent that these costs affect ordering costs or carrying costs.

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Economic-Order-Quantity Decision Model The EOQ minimizes the relevant ordering costs and carrying costs. ■ Relevant total costs = Relevant ordering costs + Relevant carrying costs ■ Little Video store sells packages of blank video tapes. ■ Little Video purchases packages of video tapes from White Oaks, Inc., at $15/package. ■

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Economic-Order-Quantity Decision Model Annual demand is 12,844 packages, at the rate of 247 packages per week. ■ Little 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-Quantity Decision Model ■

Little Video additional data: Relevant ordering cots per purchase order $209 Relevant carrying costs per package per year: Required annual return on investment (15% × $15) $2.25 Relevant other costs 3.25 $5.50

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Economic-Order-Quantity Decision Model The formula for the EOQ model is: EOQ =

2 DP C

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 20 - 21

Economic-Order-Quantity Decision Model EOQ =

2 x12 ,844 x$209 $5.50

976 ,144 EOQ = EOQ = 988 ■ Little Video should purchase 988 tape packages per order to minimize total ordering and carrying costs. 20 - 22

Economic-Order-Quantity Decision Model What are the relevant total costs? ■ The formula for annual relevant costs (RTC) is: RTC = Annual relevant ordering costs + Annual relevant carrying costs ■

RTC = D Q ■

( ) Q× P + ( ) ×DP C= 2

Q

+ QC 2

Q can be any order quantity, not just the EOQ. 20 - 23

Economic-Order-Quantity Decision Model When Q = 988 units, ■ RTC = 12,844 × $209 + 988 × $5.50 = 988 2 $5,434 total relevant costs ■

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Economic-Order-Quantity Decision Model How many deliveries should occur each time period? ■ The number of deliveries each time period is: ■

D EOQ

12,844 = 988

= 13 deliveries

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Relevant Total Costs (Dollars)

10,000

Economic-Order-Quantity Decision Model

8,000

Annual relevant total costs

6,000 5,434 Annual relevant ordering costs

4,000

2,000

Annual relevant carrying costs

Order Quantity (Units)

600

988 1,200 EOQ

1,800

2,400

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Reorder Point The reorder point is the quantity level of the inventory on hand that triggers a new order. ■ The reorder point is simplest to compute when both demand and purchase-order lead time are known with certainty. ■ Reorder point = Number of units sold per unit of time × Purchase-order lead time ■

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Reorder Point ■ –

What is the reorder point for Little Video? Economic order quantity = 988 packages

Number of units sold/week = 247 packages – Purchase-order lead time = 2 weeks ■ Reorder point = 247 × 2 = 494 packages –

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Reorder Point ■

Little Video will order 988 packages of tapes each time its inventory stock falls to 494 packages.

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Reorder Point 988 Reorder Point

Reorder Point

494

Weeks

1

2

3

4

5

6

7

8

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 - 30

Safety Stock Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. ■ Safety stock is used as a buffer against unexpected increases in demand or lead time and unavailability of stock from suppliers. ■

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Safety Stock Little Video’s expected demand is 247 packages per week. ■ Management feels that a maximum demand of 350 packages per week may occur. ■ Management decides that the costs of stockouts are prohibitive. ■ How much safety stock should be carried? ■

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Safety Stock 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 Obtaining Estimates of Relevant Costs Obtaining accurate estimates of the cost parameters used in the EOQ decision model is a challenging task. ■ 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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Considerations in Obtaining Estimates of Relevant Costs ■

– –

What is the relevant opportunity cost of capital? It is the return forgone by investing capital in inventory rather than elsewhere. It is calculated as the required rate of return multiplied by those costs per unit that vary with the number of units purchased and that are incurred at the time the units are received. 20 - 35

Cost of Prediction Error Predicting relevant costs requires care and is difficult. ■ Assume that Little Video’s 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 =

2 x 12 ,844 x 97 .84 $5 .50

456 ,966 EOQ = packages = 676 (approx.) 20 - 37

Cost of Prediction Error ■

The annual relevant total costs when EOQ is 767 packages is: DP QC RTC = + 2 Q 12,844 × $97.84 + 676 × $5.5 = $3,718 676 2 20 - 38

Cost of Prediction Error Step 2: Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost input. ■ The planned action when the relevant ordering costs per purchase order are predicted to be $209 is to purchase 988 packages in each order. ■

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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 × $5.5 988 2 ■ RTC = $3,989 ■

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Cost of Prediction Error Step 3: Compute the difference between the monetary outcomes from Steps 1 & 2. ■ Monetary Outcome 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 models and models used for performance evaluation 20 - 42

Evaluating Managers and Goal-Congruence Issues ■

Goal-congruence issues can arise when there is an inconsistency between the EOQ decision model and the model used to evaluate the performance of the manager implementing the inventory management decisions.

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Evaluating Managers and Goal-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 so that there is goal-congruence between managers and the company. ■

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Just-In-Time Purchasing Just-in-time (JIT) purchasing is the purchase of goods or materials such that a delivery immediately precedes demand or use. ■ Just-in-time purchasing can be implemented in both the retail and manufacturing sectors of the economy. ■

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JIT Purchasing and EOQ Model Parameters 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. ■ This cost includes storage costs, spoilage, obsolescence, and opportunity costs such as investment tied up in inventory. ■

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JIT Purchasing and EOQ Model 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-run purchasing arrangements. ■

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JIT Purchasing and EOQ Model Parameters Companies are using electronic link, 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). ■ Both increases in the carrying cost (C) and decreases in the ordering cost per purchase order (P) result in smaller EOQ amounts. 2

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Relevant Costs of JIT Purchasing When comparing two or more purchasing policies the analysis should include only the relevant costs – those costs that differ between alternatives. ■ The difference between two incremental costs is the relevant savings from choosing a given purchasing policy. ■

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Supplier Evaluation The timely delivery of quality products is particularly crucial in JIT purchasing environments. ■ Defective goods and late deliveries often result in contribution margin lost on current and future sales. ■ Companies that implement JIT purchasing choose their suppliers carefully. ■

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Supplier Evaluation ■ – – – – – –

What are some examples of relevant costs? Purchasing costs Ordering costs Inspection costs Stockout costs Customer returns costs Outlay carrying costs 20 - 51

Learning Objective 4 Use a supply-chain approach to inventory management

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Supply-Chain Analysis ■

The level of inventory held by retailers is influenced by demand patterns of their customers and supply relationships with their distributors, manufacturers, and suppliers.

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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. ■ There are significant total gains to companies in the supply chain from coordinating their activities and sharing information. ■

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Supply-Chain Analysis The higher level of variability at suppliers than at manufacturers, and at manufacturers than at retailers, is called the “bullwhip effect” or the “whiplash effect.” ■ One consequence of the bullwhip effect is that high levels of inventory are often held at various stages in the supply chain. ■

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Supply-Chain Analysis There are multiple gains to companies in a supply chain by coordinating their activities and sharing information. ■ Updated sales information reduces the level of uncertainty that manufacturers and suppliers have about retail demand. ■

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Supply-Chain Analysis ■ – – – –

A reduction in demand uncertainty may... lead to fewer stockouts at the retail level. reduce the number of units manufactured not subsequently demanded by retailers. reduce the number of expedited manufacturing orders. lower inventories being held by each company in the supply chain. 20 - 57

Learning Objective 5 Differentiate materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing

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Materials Requirement Planning (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. ■ Inventory management is a key challenge in an MRP system. ■

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Materials Requirement Planning (MRP) ■ – –

–

Materials requirement planning uses... demand forecasts for the final products. a bill of materials outlining the materials, components and subassemblies of each final product. the quantities of materials, components, finished products and product inventories. 20 - 60

Materials Requirement Planning (MRP) ■

1

2

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 at a plant, the downtime costs, and carrying costs of inventory. 20 - 61

Learning Objective 6 Identify the major 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. ■ Demand triggers each step of the production process, starting with customer demand for a finished product at the end of the process, to the demand for direct materials at the beginning of the process. ■

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Major Features of a JIT System ■ – –

JIT production systems aim to simultaneously meet customer demand in a timely way... with high quality products, and... at the lowest possible total cost.

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Major Features of a JIT System ■ 1 2 3 4 5

The five major features of a JIT system are: Organizing production in manufacturing cells Hiring and retaining multi-skilled workers Emphasizing total quality management Reducing manufacturing lead time and setup time Building strong supplier relationships 20 - 65

Benefits of JIT Systems ■ – –

Benefits of JIT production: Lower carrying costs of inventory Eliminating the root causes of rework, scrap, waste, and manufacturing lead time.

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Performance Measures and Control in JIT Production To manage and reduce inventories, the management accountant must design performance measures to control and evaluate JIT production. ■ What information may management accountants use? – Personal observation by production line workers and managers ■

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Performance Measures and Control in JIT Production Financial performance measures, such as inventory turnover ratios ■ What are nonfinancial performance measures of time, inventory, and quality? – Manufacturing lead time – Units produced per hour – Days’ inventory on hand –

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Performance Measures and Control in JIT Production – –

Total setup time for machines/Total manufacturing time Number of units requiring rework or scrap/Total number of units started and completed

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JIT’s Effect on Costing Systems In reducing the need for materials handling, warehousing and incoming inspection, JIT systems reduce overhead costs. ■ JIT systems also facilitate the direct tracing of some costs that were formerly classified as overhead. ■

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Learning Objective 7 Use backflush costing

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Backflush Costing A unique production system such as JIT often leads to its own unique costing system. ■ Organizing manufacturing in cells, reducing defects and manufacturing lead time, and ensuring timely delivery of materials enables purchasing, production, and sales to occur in quick succession with minimal inventories. ■

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Backflush Costing Traditional normal and standard costing systems use sequential tracking. ■ Sequential tracking is any product-costing method where recording of the journal entries occurs in the same order as actual purchases and progress in production. ■

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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. ■ A sequential tracking costing system would have four trigger points, corresponding to separate journal entries being made at different stages. ■

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Trigger Points Stage A: Purchase of direct materials ■ Stage B: Production resulting in work in process ■ Stage C: Completion of a good finished unit or 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 Account Title 1. Combined materials Inventory: Raw and materials in work-in- and In-Process process inventory Control ■ 2. Finished goods 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 Account Title Combines direct materials Inventory inventory and any direct Control materials in work-in-process and finished goods inventories ■

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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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Trigger Points Assume trigger points C and D. ■ What is the journal entry when trigger point A occurs? ■ No journal entry. ■

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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) ? ■ Finished Goods Control XX Accounts Payable 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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End of Chapter 20

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