Module 04

Module 4: Inventory managementOverview

Module 4 examines the relationship between inventory management and relevant costs of inventory. You learn more about the effects of carrying costs, economic order quantity (EOQ), and just-in-time (JIT) inventory and production systems. You compare backflush costing with traditional costing systems and conclude your work on Module 4 with a case study on implementing a JIT costing system.

Test your knowledge

Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required.

Assignment reminder

Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). If you have not already done so, review the assignment now so that you are familiar with the requirements as you work through Modules 4 and 5.

Topic outline and learning objectives

4.1 Inventory management and EOQ Make recommendations based on the calculation of total annual relevant costs, economic order quantity, re-order points, and safety stock levels. (Level 1)

4.2 Estimating inventory-related costs Describe the impact of errors in estimating inventory-related costs, and explain the importance of goal congruence. (Level 2)

4.3 Relevance and the JIT strategy of supply-chain management

Describe the role of JIT strategy and supply-chain analysis and management. (Level 2)

4.4 MRP and ERP inventory management systems

Describe materials requirement planning and enterprise resource planning production systems. (Level 2)

4.5 Backflush costing Prepare journal entries for inventory transactions using backflush costing in a JIT environment. (Level 1)

4.6 Case: Supply-chain management Analyze a supply-change management scenario, and make recommendations. (Level 1)

Module summary

Print this module

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Updated August 16, 2010, MA2-TU02, September 7, 2010, MA2-TU04

4.1 Inventory management and EOQ

Learning objective

Make recommendations based on the calculation of total annual relevant costs, economic order quantity, re-order points, and safety stock levels. (Level 1)

Required reading

Chapter 20, pages 964-973

LEVEL 1

Inventory management requires planning, coordinating, and controlling activities related to the flow of inventory to the company, through the organization (value chain), and to the final customer. For operations such as supermarkets, retail stores, and manufacturing companies, inventory represents the largest single cost. Inventory can also be a source of competitive advantage through the product itself and also through the use of efficient distribution channels.

In addition to costs of quality (Module 3), the following are major costs associated with inventory management:

Purchasing costs of acquiring goods from suppliers, including incoming freight or transportation costs and discounts

Ordering costs of preparing, issuing, and paying purchase orders, and receiving, processing, and inspecting orders

Carrying costs of holding an inventory of goods for sale, including opportunity costs of investment tied up in inventory and costs associated with storage (space rental, insurance, obsolescence, spoilage); carrying the right amount of inventory can reduce carrying costs, and carrying too little inventory creates the possibility of stockouts

Stockout costs incurred when an organization runs out of an item for which there is customer demand; includes costs of expediting orders from suppliers, and opportunity costs of lost contribution margin and customer dissatisfaction

Shrinkage costs arising from theft, embezzlement, misclassification, and clerical errors; control of shrinkage is a primary concern for managers, especially in retail operations

Advances in information technology such as radio-frequency identification, bar coding, and scanning technology increase the reliability and timeliness of inventory information, and help reduce inventory costs.

Economic order quantity (EOQ)

A key focus of inventory control is the question of how much inventory to carry. When making this decision, managers consider the costs of ordering and carrying inventory. In your introductory management accounting course you learned that the economic order quantity (EOQ) is a decision model that takes these costs into account when determining the optimal amount of inventory to keep on hand to satisfy customer demand and to reduce costs.

Work through the following example to calculate economic order quantity and to determine when to re-order running shoes at a sporting equipment retail store.

Example 4.1-1: Inventory management at Sanpan Inc.

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Sanpan Inc. sells sporting equipment. One brand of high-tech running shoe Sanpan orders regularly costs $60. The shipments are made FOB destination (meaning the seller pays all shipping costs). Annual demand is 8,000 pairs of the shoes. The company has a required rate of return of 12% on investments. Purchase order lead time is 7 days. Relevant insurance costs, material-handling, and so on, is $1200 per year. Relevant ordering costs are $40 per order. Calculate EOQ

Relevant carrying costs = $1200.00 8000 + (12% $60.00) = $0.15 + $7.20 = $7.35

The total annual relevant costs (TRC) can be calculated as:

Total relevant costs = Ordering costs + Carrying costs

TRC = (D/Q) x P + (Q/2) x C or TRC = (DP/Q) + (QC/2)

*Q can be any quantity ordered, not necessarily the EOQ.

Here is the TRC for the EOQ:TRC = (D/Q) P + (Q/2) C = (8,000 295) x $40.00 + (295 2) x $7.35 = $1,085.00 + $1,085.00 = $2,170.00

The number of deliveries each time period would be as follows: D/EOQ = 8,000 295 = 27.11, or 28 deliveries. Re-order point

Re-order point = Number of units sold (per unit of time) x Purchase order lead time.

Using the Sanpan inventory data, you can calculate the reorder point as follows:

Number of units sold per week: 8,000 52 = 154 pairs.

Re-order point = 154 pair of running shoes per week x 1 week = 154.

When the inventory falls to 154 pairs of running shoes (out of the 295 pairs per order), the company should reorder.

Safety stock

Because of uncertainties of demand, companies hold a safety stock, or cushion of inventory, to use as a buffer against problems in delivery or to reduce the chance of stockout situations. To calculate safety stock, managers consider relevant stockout costs including costs of rush shipments and inventory carrying costs. The optimal safety stock level minimizes stockout costs and carrying costs.

When companies hold a safety stock, the reorder point calculation is adjusted as follows:

Re-order point = Number of units sold (per unit of time) x Purchase order lead time + Safety stock.



Activity 4.1-1: Economic order quantity

To test your understanding of the application of EOQ calculations, work through Activity 4.1-1, checking your answers for each problem as you go.

Just-in-time (JIT) purchasing

JIT purchasing aims to reduce carrying costs, scrap, obsolescence, and non-value added time, with resulting increased customer satisfaction. With JIT purchasing, delivery of goods or materials immediately precedes their demand or use. A JIT system affects both the buyer and seller in the supply chain because it requires more frequent and smaller order lots from suppliers. This type of system works well when availability and prices of resources are constant and production cycles are well controlled.

JIT systems result in reduced carrying costs of inventory such as warehousing, insurance, and labour, which dramatically decreases parameter C (carrying cost of one unit) in the EOQ calculation on page 966. Because of close trading partner relationships, P (relevant ordering costs) in the EOQ calculation can also be reduced despite more frequent ordering. Page 970 provides a list of three factors causing reductions in ordering costs in a JIT purchasing environment. Decreased inventory may reduce the need for warehousing and some fixed costs, which would also reduce the C component. Because companies using JIT usually enter into long-term purchasing agreements, JIT may also reduce P or ordering costs. JIT systems can also have a positive effect on quality because engineers from the buying company often work with the supplier to ensure quality at the source. E-commerce can increase efficiency and reduce costs of JIT order processing when companies make orders with online purchasing cards (similar to credit cards).

Potential drawbacks to a JIT system include

problems with quality of inputs when the buyer does not have a backup of material to deal with quality problems late delivery of materials, which can shut down a manufacturing plant, and increase in ordering costs resulting from smaller purchase lots, which must be considered in negotiating with

suppliers.

JIT production

JIT production (also called lean production) is a "demand-pull" system. The components of the manufacturing system are produced immediately before needed by the next link in the supply chain. Here are the main features of a JIT production system:

Production is organized into manufacturing cells, with machines and equipment grouped together to make a particular product in a sequential manner.

Workers are trained to be multi-skilled and capable of performing a variety of operations, including maintenance and repair, which allows greater flexibility.

Defects are aggressively managed through a total quality management (TQM) system, using tight linkages and minimal inventories. TQM is an essential component of the JIT system.

Setup and manufacturing lead-times are reduced, making production in smaller batches more economically feasible.

Suppliers are selected based on ability to deliver quality products in a timely manner. Dell Canada is a well-known example of an organization that has implemented a successful JIT production system.


4.2 Estimating inventory-related costs

Learning objective

Describe the impact of errors in estimating inventory-related costs, and explain the importance of goal congruence. (Level 2)

Required reading


LEVEL 2

Relevant costs are those that change between alternatives. The total annual relevant costs associated with estimating inventory include

costs that change with varying levels of inventory, such as insurance, property taxes, obsolescence, breakage, spoilage, rent or storage space (opportunity costs)

salaries and utilities, and ordering and stockout costs.

It is important to understand that many of these costs do not vary when one more unit of inventory is added. For example, a company would need to add significant amounts of inventory to increase the property taxes paid in a year or to require additional warehouse space. Care needs to be taken in estimating these costs; as the following calculations show, however, the cost difference of a prediction error is usually small.

Estimating total annual relevant inventory costs (TRC) and costs of a prediction error

Refer to Example 4.1-1 and assume that P = $60.00 instead of $40.00. Determining the costs of a prediction error requires the following steps:

1. Calculate the total annual relevant costs from the best action that could have been taken given the actual amount of cost input.

TRC = (D/Q) P + (Q/2) C = (8,000 362) $60.00 + (362 2) $7.35 = $1,326.00 + $1,330.00 = $2,656.00

2. Calculate the total annual relevant costs from the best action on the basis of the incorrect amount of predicted cost input. TRC =(D/Q) P + (Q/2) C =(8,000 295) $60.00 + (295 2) $7.35 =$1,627.00 + $1,084.00 =$2,711.00

3. Calculate the difference between the two total annual relevant costs calculated in steps 1 and 2. $2,656.00 $2,711.00 = ($55.00) cost of prediction error.

Importance of goal-congruence in inventory management




Two key opportunity costs are important issues in inventory management stockout costs and carrying costs. For stockout costs, the contribution margin on lost sales is an opportunity cost. For carrying costs, lost revenue on the investment or cash tied up in inventory are opportunity costs. These opportunity costs are not usually recorded in the accounting system. The model used must ensure that the relevant opportunity costs are taken into consideration because if they are not part of performance evaluation, managers may consider counterproductive decisions. For example, if a purchasing manager were to be evaluated solely on the basis of no stockouts, that manager would have an incentive to order larger quantities than the EOQ model suggests is optimal. To create goal congruence, the purchasing manager should be evaluated on a performance measure that includes the opportunity costs of carrying excessive inventory.


4.3 Relevance and the JIT strategy of supply-chain management

Updated September 7, 2010, MA2-10-TU04

Learning objective

Describe the role of JIT strategy and supply-chain analysis and management. (Level 2)

Required reading

Chapter 1, pages 5-8 (The Value Chain of Business Functions Leads to the Customer) Chapter 20, pages 976-980 and page 982 (Real Companies: Challenge: Securing the Benefits of Good Supply-Chain

Management)

Note on the textbook readings

On page 980, the third bullet at the top of the page should read: "Nonfinancial performance measures of time, inventory, and quality, such as manufacturing lead time, units produced per hours, and days' inventory on hand."

LEVEL 2

Demand and buying behaviours of customers and supply relationships with distributors and manufacturers affect the levels of inventory held. The term supply chain describes the flow of goods or services and information from raw materials (or the initiating moment) to the final customer, and often beyond because of recycling initiatives. An example of a supply chain in the book publishing industry might include forestry operations, paper producers, authors, editors, graphic artists, distributors, bookstores, paper recycling facilities, and so on. In tourism, a supply chain usually includes travel agents, airlines, hotels and restaurants, and other tourist destinations.

Supply-chain analysis and management oversees the entire process and flow of goods, services, and information from "womb to tomb" (creation to disposal), as described in the text on page 6. This includes managing the initial purchase of raw materials, production and sale of the finished product, after-sales service, and even disposal of the product. For example, Dell Computers offers a recycling service to purchasers of their computer products.

Increased coordination within a supply chain helps reduce information asymmetry and uncertainty and leads to a better working relationship, with fewer stockout situations. However, many companies are reluctant to share information for fear of being eliminated from the supply chain when suppliers or customers integrate the companys processes into their own.

Calculating JIT relevant costs

Exhibit 20-5 (page 977) shows the current relevant costs and JIT relevant costs, and calculates the savings realized in moving to a JIT purchasing system. Caution should be taken in doing these calculations. Managers should perform a full sensitivity analysis to show the impact of changes in the important parameters such as stockout and ordering costs.

To illustrate the significant changes that JIT purchasing can have in the costs of purchasing and in the economic order quantity, work through the following computer illustration.

Computer illustration 4.3-1: Economic order quantity in a JIT operation


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Computer illustration 4.3-1: Economic order quantity in a JIT operation

Kurian Image Maker Ltd. (KIM) designs and manufactures props for Bollywood and Hollywood. An ongoing materials requirement for KIM is the need for plywood for scenery used to change the exterior and interior of buildings to suit the script by building shells and fake walls. Baldev Kurian, the vice-president of supply-chain management, is looking at improving the plywood procurement process. His first step is to determine which suppliers are ISO compliant and to assess their delivery records, which narrows the suppliers to two. Now he is looking at the costs involved; an analysis of the past three years provides the following information.

Annual demand for plywood 36,000 sheetsOrdering costs per purchase order $357Carrying costs per year 16% of purchase costSafety stock requirements 10 sheetsCost per sheet $12.50

The lead time is 3 days. KIM operates and produces goods 365 days a year.

Material provided

File MA2M4P1 containing a partially completed worksheet M4P1 and the solution worksheet M4P1S.

Required

1.

a.

Using the information given in the data table based on the information provided above, determine the economic order quantity for Kurian Image Makers. What is the total annual relevant cost (TRC) for purchasing plywood?

b. What is the re-order point? (See page 968, and remember to include safety stock in the calculation.)

2.

a.

As KIM uses plywood on a steady basis, Baldev wonders if JIT purchasing might be more cost effective. If he decides to use JIT, carrying costs will be reduced to 5%. Order costs will rise 10%. The price per sheet is negotiated annually and will not change. Recalculate the economic order quantity based on using JIT.

b. What is the TRC now?

c. Is JIT a good idea?

Procedure

1. Start Excel.

2. Open the file MA2M4P1. Go to TAB M4P1.

3. Review the spreadsheet. Note that the data table replicates the information given above and is contained between cells A5 and G20.

4. In cell C24, enter the formula referencing the data table for total demand for part 1.

5. In cell C26, enter the formula for annual carrying costs.

6. In cell C28, enter the formula for order costs.

7. In cell C30, enter the formula for EOQ using the calculated numbers from the previous three steps.

8. In cells E24, E26, E28, and E30 repeat steps 4, 5, 6, and 7 using the JIT information.

Conclusion

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1. a. Demand: 36,000 Carrying costs: $72,000 ($2 per unit) Order costs: $357 EOQ: 3,585 TRC: $7,170

b.

Re-order point: = 306

2. a. Demand: 36,000 Carrying costs: $22,500 ($0.625 per unit) Order costs: $392.70 EOQ: 6,726

b. TRC = $4,204

c. The total annual relevant costs are reduced significantly under JIT purchasing from $7,170 to $4,204. The number of orders goes down as ordering costs increase and carrying costs are reduced. Baldev should look into the option of using the Internet for placing purchase orders, as this would simplify the process.

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4.4 MRP and ERP inventory management systems

Learning objective

Describe material requirement planning and enterprise resource planning production systems. (Level 2)

Required reading


LEVEL 2

Material requirement planning (MRP) is a "push-through" system that schedules the manufacture of finished goods for inventory on the basis of expected demand forecasts. Taking into account the lead-time in the production process and other internal factors such as the bill of materials and available production inventories, managers use this system to provide a master production schedule for determining output levels required at each stage in the manufacturing process. Although scheduling and tracking of goods from raw materials to work-in-process and finished goods is a major challenge in successful implementation of MRP systems, MRP can also lead to increased efficiencies in plant design, labour schedules, and supply-chain management. Management accountants can use MRP to develop estimates of setup, downtime, and carrying costs to help develop efficient schedules and determine accurate processing costs.

Enterprise resource planning (ERP) systems integrate accounting, distribution, manufacturing, planning, purchasing, human-resource and other systems into a single database, which reduces the possibility of errors from running multiple separate systems and also enhances the ability to plan and coordinate processing activities.

JIT and ERP systems

JIT requires a focus on information flows within the company and between the company and its suppliers/customers. This process can be aided by an ERP system that links all company information through a centralized database. ERP can link purchasing, production, accounting, and distribution to provide information that managers use to improve coordination and reduce overhead costs. These systems can also serve to improve communication between suppliers and customers within the supply chain.



Updated October 4, 2010, MA2-10-TU07

4.5 Backflush costing

Learning objective

z Prepare journal entries for inventory transactions using backflush costing in a JIT environment. (Level 1)

Required reading

z Chapter 20, pages 983-990

LEVEL 1

The unique features of JIT systems lead to changes in the traditional accounting flow because the elimination of inventories renders decisions about weighted-average or FIFO and absorption or variable costing irrelevant. Traditional costing systems require sequential tracking using specific trigger points to recognize journal entries as shown in the following exhibit.

Exhibit 4.5-1: Production cycle using T-accounts

Backflush costing in a JIT environment eliminates some or all journal entries related to the production cycle. The system then focuses on the production of finished goods, and makes journal entries using either standardor normal costing. The completion of a finished good triggers journal entries from direct materials and conversion costs to the finished good. Data for variance analysis can also be simultaneously calculated by using other systems, such as payroll, within the ERP system. Scrap, rework, and spoilage costs can then be added to correct any discrepancies and ensure accurate costing.

Different versions of backflush costing result from the setup of different operation and trigger points. Exhibits 20-7 and 20-8 (on pages 986-997) show the journal entries and general ledger overview transaction flow

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under three scenarios. The following example also demonstrates these journal entries under backflush costing.

Example 4.5-1: Accounting flow under backflush costing

Trigger points are stages A, C, and D.

Assume a company has trigger points of purchase for direct materials, completion of finished goods, and sale of finished goods. Standard costs per unit for direct materials are $22 and conversion costs are $32. The company produced 10,000 units during the period. Purchases of direct material at standard cost were $300,000. Actual conversion costs for the period were $310,000. The company had no beginning or ending inventory balances. Sales were made of 9,000 units at $80 per unit.

1. Record direct material purchased.

2. Record the incurrence of actual conversion costs during period.

3. Compute the budgeted standard cost per unit.

Standard cost = Direct materials ($22) + Conversion costs ($32) = $54 per unit

4. Record finished goods completed during period.

5. Record the sales for the period.

6. Record under-or over-allocated conversion costs.

JIT systems typically include little work-in-process or direct materials inventory, and so they do not require prorating under- or over-allocated conversion costs (or manufacturing overhead). Companies simply charge the under- or over-allocated cost to Cost of goods sold.

Note that in this case two conversion cost accounts are used; one to record the actual costs and one to record the allocated costs. Another method of recording these costs is to simply debit a single conversion cost control account with actual costs and credit it with applied costs.

Inventory: Raw material and in-process control 300,000 Accounts payable control 300,000

Conversion costs control 310,000 Accounts payable, wages payable 310,000

Finished goods control 540,000 Inventory: Raw and In-Process Control 220,000 Conversion costs allocated 320,000

Cash or accounts receivable 720,000 Revenue 720,000 Cost of goods sold 486,000 Finished goods control 486,000

Conversion costs allocated 320,000 Cost of goods sold 10,000 Conversion cost control 310,000

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Backflush costing, GAAP, and IFRS

The accounting flow under backflush costing does not strictly adhere to GAAP or IFRS for external reporting purposes. Work in process is not recognized in these examples but it should show up in the inventory breakdown in the notes to the financial statements. Advocates of backflush accounting argue that because of the small amount of inventory in Work in process, materiality does not require the breakdown of inventories tosuch levels. Critics also point out that there is no audit trail when using backflush accounting.

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4.6 Case: Supply-chain management

Learning objective

Analyze a supply-chain management scenario, and make recommendations. (Level 1)

LEVEL 1

The following data from Welsh Manufacturing Ltd. are provided to give a perspective of supply-chain management.

Case 4.6-1: TQM and JIT at Welsh Manufacturing Ltd.

Jack Hughes, president of Welsh Manufacturing Ltd., is concerned about the increase of production costs for the A45 from $4.50 per unit six months ago to the current cost of $6.65 per unit. It appears that profit targets for the current year will not be met. Jerry Brice, manager of purchasing agrees to look into the matter.

1. The company uses a normal costing system with budgeted material costs of $1.50 per unit, direct-labour costs of $2.00 per unit, and manufacturing overhead charged at 50% of direct-labour costs.

2. Eight months ago, Jerrys department decided to use multiple suppliers so that the company would not be exclusively tied to one major supplier. Many of the new suppliers are resellers who buy materials from various sources and resell them to Welsh at a markup.

The company uses a just-in-time production system and therefore work-in-process and finished goods inventories are negligible.

Required

What additional issues arise when the company uses a just-in-time inventory system?

Solution



Case: TQM and JIT at Welsh Manufacturing

Solution

That the company uses a just-in-time inventory system places additional pressure on Jerry to focus on the suppliers of product to the A45 product line. The use of resellers as suppliers is a concern; since the product they supply could come from any number of additional suppliers to the reseller, the probability of manufacturing high-quality products is reduced.

When a company uses a JIT inventory system, the focus is on reducing the number of suppliers, and focusing on quality and on-time delivery more than on cost. Moving from one supplier to a small number of suppliers is not harmful to the company, whereas having only one supplier can create additional problems. For example, a difficulty with the supplier, such as a workers strike or a plant shut-down, would create a shortage of available supply, potentially shutting down Welshs production line.

Jerry needs to gather information about on-time delivery from potential suppliers in choosing which suppliers to work with, including performing an EOQ analysis. He should also ensure that the suppliers are compliant with international quality standards.

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Module 4 self-test

Question 1

Exercise 20-16, page 996

Solution

Question 2

Exercise 20-22, pages 997-998

Solution

Question 3

Exercise 20-23, page 998

Solution

Question 4

Exercise 20-24, page 998 Ignore requirement 2.

Solution

Question 5

Problem 20-28, pages 999-1000

Solution

Question 6

Problem 20-31, page 1001 Ignore requirement 2.

Solution

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Self-test 4

Solution 1

20-16 Economic order quantity for retailer 1. D = 10,000, P = $200, C = $7

7

200$000,102CDP 2 EOQ == =755.93756jerseys

2. Number of orders per year = EOQ

D = 756

000,10 = 13.22 14 orders

3. day workingeach Demand =

days workingofNumber D =

365000,10 = 27.40 jerseys per day

Purchase lead time = 7 days Reorder point = 27.40 7 = 191.80 192 jerseys

Self-test 4

Solution 2

20-22 Purchase-order size for retailer, EOQ, just-in-time purchasing

1. EOQ = 2DPC

(a) D = 7,200; P = $36; C = $1.20

EOQ = = =2(7,200) ($36) 432,000 657.3 cases @658 cases$1.20

(b) D = 7,200; P = $36; C = $1.80

EOQ = 2(7,200) ($36) 288,000 536.7 cases 537 cases$1.80

= =

(c) D = 7,200; P = $6; C = $1.80

EOQ = 2(7, 200) ($6) 48,000 219.1 cases 220 cases$1.80

= = 2. A just-in-time purchasing policy involves the purchase of goods such that their

delivery immediately precedes their demand. Given the purchase order sizes calculated in requirement 1, the number of purchase orders placed each month is (D EOQ):

(a) D 7, 200

EOQ 658= = 11 orders per month or 1 every 2.7 days

(b) D 7, 200 EOQ 537

= = 14 orders per month or 1 every 2.15 days (c) D 7, 200

EOQ 220= = 33 orders per month or 1 every 0.91 days

An increase in C and a decrease in P led to increases in the optimal frequency of orders. The 24-Hour Mart has increased the frequency of delivery from every third day (1a: P = $36; C = $1.20) to a delivery every day (1c: P = $6; C = $1.80). There is a reduction of 219 cases in the average inventory level: (658 220) 2 = 219.

Self-test 4

Solution 3

20-23 JIT production, relevant benefits, relevant costs 1. Solution Exhibit 20-23 presents the annual net benefit of $315,000 to Champion

Hardware Company of implementing a JIT production system. 2. Other nonfinancial and qualitative factors that Champion should consider in

deciding whether it should implement a JIT system include: a. The possibility of developing and implementing a detailed system for

integrating the sequential operations of the manufacturing process. Direct materials must arrive when needed for each subassembly so that the production process functions smoothly.

b. The ability to design products that use standardized parts and reduce manufacturing time.

c. The ease of obtaining reliable vendors who can deliver quality direct materials on time with minimum lead time.

d. Willingness of suppliers to deliver smaller and more frequent orders. e. The confidence of being able to deliver quality products on time. Failure to do so

would result in customer dissatisfaction. f. The skill levels of workers to perform multiple tasks such as minor repairs,

maintenance, quality testing, and inspection.

SolutionExhibit2023

AnnualRelevantCostsofCurrentProductionSystemandJITProductionSystemforChampionHardwareCompany

RelevantItems

RelevantCostsunderCurrentProductionSystem

RelevantCostsunderJITProductionSystem

Annualtoolingcosts $100,000 Requiredreturnoninvestment: 15%peryear$1,000,000ofaverageinventoryperyear $150,000 15%peryear$200,000aofaverageinventoryperyear 30,000Insurance,space,materialshandling,andsetupcosts 300,000 225,000bReworkcosts 200,000 140,000cIncrementalrevenuesfromhighersellingprices (160,000)dTotalnetincrementalcosts $650,000 $335,000AnnualdifferenceinfavourofJITproduction $315,000 a $1,000,000 (1 80%) = $200,000 b$300,000 (1 0.25) = $225,000 c$200,000 (1 0.30) = $140,000 d$4 40,000 units = $160,000 Other nonfinancial and qualitative factors that Champion should consider in deciding whether it should implement a JIT system include the following: a. The possibility of developing and implementing a detailed system for

integrating the sequential operations of the manufacturing process. Direct materials must arrive when needed for each subassembly so that the production process functions smoothly.

b. The ability to design products that use standardized parts and reduce manufacturing time.

c. The ease of obtaining reliable vendors who can deliver quality direct materials on time with minimum lead time.

d. Willingness of suppliers to deliver smaller and more frequent orders. e. The confidence of being able to deliver quality products on time. Failure to do so

would result in customer dissatisfaction. f. The skill levels of workers to perform multiple tasks such as minor repairs,

maintenance, quality testing, and inspection. 3. Personal observation by production line workers and managers is more effective in

JIT plants than in traditional plants. A JIT plants production process layout is streamlined. Operations are not obscured by piles of inventory or rework. As a result, such plants are easier to evaluate by personal observation than cluttered plants where the flow of production is not logically laid out.

Besides personal observation, nonfinancial performance measures are the dominant methods of control. Nonfinancial performance measures provide most timely and easy to understand measures of plant performance. Examples of nonfinancial performance measures of time, inventory, and quality include:

Manufacturingleadtime. Unitsproducedperhour. Machinesetuptimemanufacturingtime. Numberofdefectiveunitsnumberofunitscompleted.

In addition to personal observation and nonfinancial performance measures,

financial performance measures are also used. Examples of financial performance measures include:

Costofrework. Orderingcosts. Stockoutcosts. Inventoryturnover(costofgoodssold averageinventory).

The success of a JIT system depends on the speed of information flow from

customers to manufacturers to suppliers. The Enterprise Resource Planning (ERP) system has a single database, and gives lower-level managers, workers, customers, and suppliers access to operating information. This benefit, accompanied by tight coordination across business functions, enables the ERP system to rapidly transmit information in response to changes in supply and demand so that manufacturing and distribution plans may be revised accordingly.

Self-test 4

Solution 4

20-24 Backflush costing and JIT production 1.

(a)Purchasesofdirectmaterials Inventory:MaterialsandInProcessControl 2,754,000

AccountsPayableControl 2,754,000 (b)Incurconversioncosts ConversionCostsControl 723,600

Various Accounts 723,600 (c)Completionoffinishedgoods FinishedGoodsControl

Inventory:MaterialsandInProcessControl

3,484,000a

2,733,600 ConversionCostsAllocated 750,400 (d)Saleoffinishedgoods CostofGoodsSold 3,432,000b FinishedGoodsControl 3,432,000a26,800 ($102 + $28) = $3,484,000 b26,400 ($102 + $28) = $3,432,000

Omit part 2 3. Under an ideal JIT production system, there could be zero inventories at the end of

each day. Entry (c) would be $3,432,000 finished goods production, not $3,484,000. Also, there would be no inventory of direct materials instead of $2,754,000 $2,733,600 = $20,400.

Self-test 4

Solution 5

20-28 Effect of different order quantities on ordering costs and carrying costs, EOQ

1. Scenario

1 2 3 4 5Demand(units)(D) 234,000 234,000 234,000 234,000 234,000Costperpurchaseorder(P) $81.00 $81.00 $81.00 $81.00 $81.00Annualcarryingcostperpackage(C) $11.70 $11.70 $11.70 $11.70 $11.70Orderquantityperpurchaseorder(units)(Q) 900 1,500 1,800 2,100 2,700Numberofpurchaseordersperyear(DQ) 260.00 156.00 130.00 111.43 86.67Annualorderingcosts(DQ)P $21,060 $12,636 $10,530 $9,026 $7,020Annualcarryingcosts(QC2) $5,265 $8,775 $10,530 $12,285 $15,795Totalrelevantcostsoforderingandcarryinginventory $26,325 $21,411 $21,060 $21,311 $22,815

The economic order quantity is 1,800 packages. It is the order quantity at which carrying costs equal ordering costs and total relevant ordering and carrying costs are minimized.

We can also confirm this from direct calculation. Using D = 234,000; P = $81 and C = $11.70

EOQ =70.11$

81$000,2342 =1,800packages

It is interesting to note that Koala Blue faces a situation where total relevant ordering and carrying costs do not vary very much when order quantity ranges from 1,500 packages to 2,700 packages.

2. When the ordering cost per purchase order is reduced to $49:

EOQ =70.11$

49$000,2342 =1,400packages

The EOQ drops from 1,800 packages to 1,400 packages when Koala Blues ordering cost per purchase order decreases from $81 to $49. The new relevant costs of ordering inventory are:

=

P QD =

$49

400,1000,234 = $8,190

and the new relevant costs or carrying inventory are:

=

C 2Q =

$11.70

2400,1 = $8,190

The total new costs of ordering and carrying inventory = $8,190 2 = $16,380 3. As summarized below, the new Mona Lisa web-based ordering system, by lowering

the EOQ to 1,400 packages, will lower the carrying and ordering costs by $4,680. Koala Blue will spend $2,000 to train its purchasing assistants on the new system. Overall, Koala Blue will still save $2,680 in the first year alone.

TotalrelevantcostsatEOQ(fromRequirement2) $16,380Annualcostbenefitoveroldsystem($21,060$16,380) $4,680Trainingcosts 2,000Netbenefitinfirstyearalone $2,680

Self-test 4

Solution 6

20-31 Blackflush costing and JIT production 1. (a)Purchasesofdirectmaterials Inventory:MaterialsandInProcessControl 550,000 AccountsPayableControl 550,000

(b)Incurconversioncosts ConversionCostsControl 440,000 VariousAccounts 440,000

(c)Completionoffinishedgoods

FinishedGoodsControl

Inventory:Materials&InProcessControl

945,000a

525,000 ConversionCostsAllocated 420,000

(d)Saleoffinishedgoods CostofGoodsSold 900,000b

FinishedGoodsControl 900,000a 21,000 $45 ($25 + $20) = $945,000 b 20,000 $45 = $900,000

Module 4 summary

Make recommendations based on the calculation of total annual relevant costs, economic order quantity, re-order points, and safety stock levels

The major costs in inventory management are purchasing, ordering, carrying, stockout, and shrinkage costs.

TRC = (D/Q) x P + (Q/2) x C or TRC = (DP/Q) + (QC/2) Reorder point = Number of units sold (per unit of time) x Purchase order lead time.

Describe the impact of errors in estimating inventory-related costs, and explain the importance of goal congruence

Relevant costs change based on varying levels of inventory. To determine cost of prediction error requires calculating

TRC from the best action that could have been taken,

TRC from the best action based on the incorrect amount of predicted outlay, and

the difference between the two amounts.

Describe the role of JIT strategy and supply-chain analysis and management

JIT systems purchase goods on a demand-pull basis; materials arrive when they are required. JIT requires on-time delivery of smaller, more frequent orders. Benefits of JIT include reduced carrying and ordering costs. Supply chain describes the flow of goods, services, or information from the raw material or initiating event to the final

customer. Increased co-ordination within the supply chain helps reduce information asymmetry, leading to better working

relationships and fewer stockout situations. Need for increased co-ordination can create problems with sharing proprietary information.

Describe materials requirement planning and enterprise resource planning production systems

Materials requirement planning (MRP) is a push-through system based on expected demand forecasts.

An enterprise resource planning (ERP) system coordinates various functions together and allows managers to integrate decisions from production planning and scheduling to human resource management to accounting. ERP is a system that connects the flow of information between all systems in an organization.

Prepare journal entries for inventory transactions using backflush costing in a JIT environment

Backflush costing eliminates many of the traditional journal entries for inventory throughout the production cycle.

Work in process (WIP) is often the main inventory item that is deleted under backflush costing.

Trigger points for journal entries may be: purchasing raw material, putting finished goods into inventory, and sale of finished goods.

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The key point is: where an inventory trigger point is not producing a journal entry, it is because the inventory is not significant.

Analyze a supply-chain management scenario, and make recommendations

It is important to integrate the various concepts that you are learning in the course and use them in real world situations.

All costing analysis should reflect the needs of the companys overarching strategic plans.

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Module 04

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