Inventory Management, Just-in-Time, and Quality Costing

Costs Associated with Goods for Sale Five categories of costs associated with goods for sale are: Purchasing costs Ordering costs Carrying costs Stockout costs Quality costs

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.

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.

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.

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

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.

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: Prevention costs Appraisal costs Internal failure costs External failure costs

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.

Economic-Order-Quantity Decision Model 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.

Economic-Order-Quantity Decision Model 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.

Economic-Order-Quantity Decision Model The EOQ minimizes the relevant ordering costs and carrying costs. Relevant total costs = Relevant ordering costs + Relevant carrying costs The formula for annual relevant costs (RTC) is: RTC = Annual relevant ordering costs + Annual relevant carrying costs RTC = ( ) *P + ( )*C = + QC 2 D Q Q 2 DP Q

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

Economic-Order-Quantity Decision Model 10,000 8,000 Annual relevant total costs Relevant Total Costs (Dollars) 6,000 5,434 Annual relevant ordering costs 4,000 Annual relevant carrying costs 2,000 600 988 EOQ 1,200 1,800 2,400 Order Quantity (Units) 20 - 26

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.

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.

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). Companies increasingly are establishing long-run purchasing arrangements.

JIT Purchasing and EOQ Model Parameters Companies are using electronic link, such as the Internet, to place purchase orders. 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.

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.

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.

Major Features of a JIT System 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

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.

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.

Two Aspects of Quality Quality of design measures how closely the characteristics of products or services meet the needs and wants of customers. Conformance quality refers to the performance of a product or service according to design and product specifications.

Two Aspects of Quality Actual Performance Design Specifications Customer Satisfaction Conformance Quality Failure Quality of Design Failure

Costs of Quality The costs of quality (COQ) refer to costs incurred to prevent, or costs arising as a result of, the production of a low-quality product. These costs focus on conformance quality and are incurred in all business functions of the value chain.

Costs of Quality Prevention costs--costs incurred in precluding the production of products that do not conform to specifications. Appraisal costs--costs incurred in detecting which of the individual units of products do not conform to specifications.

Costs of Quality Internal failure costs--costs incurred by a nonconforming product detected before it is shipped to customers. External failure costs--costs incurred by a nonconforming product detected after it is shipped to customers.

Evaluating Quality Performance Measuring the financial costs of quality and the nonfinancial aspects of quality have distinctly different advantages. Financial measures are helpful to evaluate trade-offs among prevention costs, appraisal costs, and failure costs. They focus attention on the costs of poor quality.

Evaluating Quality Performance Advantages of COQ measures: Consistent with the attention directing role of management accounting, COQ focuses attention on how costly poor quality can be. Financial COQ measures assist in problem solving by comparing different quality-improvement programs and setting priorities for achieving maximum cost reduction.

Evaluating Quality Performance COQ provides a single, summary measure of quality performance. Nonfinancial measures help focus attention on the precise problem areas that need improvement and also serve as indicators of future long-run performance.

Evaluating Quality Performance Advantages of nonfinancial measures of quality: Nonfinancial measures of quality are often easy to quantify and understand. Nonfinancial measures direct attention to physical processes and hence focus attention on the precise problem areas that need improvement.

Evaluating Quality Performance Nonfinancial measures provide immediate short-run feedback on whether quality improvement efforts have, in fact, succeeded in improving quality. Nonfinancial measures are useful indicators of future long-run performance.