Cost Management ACCOUNTING AND CONTROL HANSEN & MOWEN

CHAPTER 21 Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints

1 Just-in-Case Inventory Management OBJECTIVE 1 Three types of inventory costs can be readily identified with inventory: The cost of acquiring inventory. The cost of holding inventory. The cost of not having inventory on hand when needed.

1 Just-in-Case Inventory Management OBJECTIVE 1 1. Ordering Costs: The costs of placing and receiving an order. Examples: Clerical costs, documents, insurance for shipment, and unloading. 2. Setup Costs: The costs of preparing equipment and facilities so they can be used to produce a particular product or component. Examples: Setup labor, lost income (from idled facilities), and test runs.

1 Just-in-Case Inventory Management OBJECTIVE 1 3. Stock-Out Costs: The costs of not having sufficient inventory. Examples: Lost sales, costs of expediting (extra setup, transportation, etc.) and the costs of interrupted production. 4. Carrying Costs: The costs of carrying inventory. Examples: Insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, and storage.

Traditional Reasons for Carrying Inventory Just-in-Case Inventory Management OBJECTIVE 1 Traditional Reasons for Carrying Inventory

1 TC = PD/Q + CQ/2 Economic Order Quantity Just-in-Case Inventory Management OBJECTIVE 1 Economic Order Quantity TC = PD/Q + CQ/2 The total ordering (or setup) and carrying cost The cost of placing and receiving an order (or the cost of setting up a production run) The known annual demand The number of units ordered each time an order is placed (or the lot size for production) The cost of carrying one unit of stock for one year

1 An EOQ Illustration Just-in-Case Inventory Management EOQ =  2PD/C OBJECTIVE 1 An EOQ Illustration EOQ =  2PD/C D = 25,000 units Q = 500 units P = $40 per order C = $2 per unit EOQ =  (2 x 25,000 x $40) / $2 EOQ =  1,000,000 EOQ = 1,000 units 8

When to Order or Produce Just-in-Case Inventory Management OBJECTIVE 1 When to Order or Produce Reorder point = Rate of usage x Lead time Example: Assume that the average rate of usage is 100 parts per day. Assume also that the lead time is 4 days. What is the reorder point? Reorder point = 4 x 100 = 400 units Thus, an order should be placed when inventory drops to 400 units.

Just-in-Case Inventory Management OBJECTIVE 1 The Reorder Point

Demand Uncertainty and Reordering Just-in-Case Inventory Management OBJECTIVE 1 Demand Uncertainty and Reordering To avoid running out of parts, organizations often choose to carry safety stock. Safety stock is extra inventory carried to serve as insurance against fluctuations in demand. Example: If the maximum usage of the VCR part is 120 units per day, the average usage is 100 units per day, and the lead time is four days, the safety stock is 80. Maximum usage 120 Average usage -100 Difference 20 Lead time x 4 Safety stock 80

EOQ and Reorder Point Illustrated Just-in-Case Inventory Management OBJECTIVE 1 EOQ and Reorder Point Illustrated

Setup and Carrying Costs: The JIT Approach JIT Inventory Management OBJECTIVE 2 Setup and Carrying Costs: The JIT Approach JIT reduces the costs of acquiring inventory to insignificant levels by: 1. Drastically reducing setup time 2. Using long-term contracts for outside purchases Carrying costs are reduced to insignificant levels by reducing inventories to insignificant levels.

Due-Date Performance: The JIT Solution JIT Inventory Management OBJECTIVE 2 Due-Date Performance: The JIT Solution Lead times are reduced so that the company can meet requested delivery dates and to respond quickly to customer demand. Lead times are reduced by: reducing setup times improving quality using cellular manufacturing

Avoidance of Shutdown: The JIT Approach JIT Inventory Management OBJECTIVE 2 Avoidance of Shutdown: The JIT Approach Total preventive maintenance to reduce machine failures Total quality control to reduce defective parts The use of the Kanban system is also essential

What is the Kanban System? JIT Inventory Management OBJECTIVE 2 What is the Kanban System? A card system is used to monitor work in process A withdrawal Kanban A production Kanban A vendor Kanban The Kanban system is responsible for ensuring that the necessary products are produced in the necessary quantities at the necessary time. 12

2 JIT Inventory Management Withdrawal Kanban Production Kanban OBJECTIVE 2 Withdrawal Kanban Production Kanban

JIT Inventory Management OBJECTIVE 2 Vendor Kanban

JIT Inventory Management OBJECTIVE 2 The Kanban Process

2 JIT Inventory Management OBJECTIVE 2 Discounts and Price Increases: JIT Purchasing versus Holding Inventories Careful vendor selection Long-term contracts with vendors Prices are stipulated (usually producing a significant savings) Quality is stipulated The number of orders placed are reduced

2 JIT Limitations JIT Inventory Management OBJECTIVE 2 JIT Limitations Patience in implications is needed. Time is required. JIT may cause lost sales and stressed workers. Production may be interrupted due to an absence of inventory.

Basic Concepts of Constrained Optimization OBJECTIVE 3 Every firm faces limited resources and limited demand for each product. External constraints, such as market demand Internal constraints, such as machine or labor time availability Constrained optimization is choosing the optimal mix given the constraints faced by the firm.

Total contribution margin Basic Concepts of Constrained Optimization OBJECTIVE 3 Linear Programming The unit contribution margins are $300 and $600 for X and Y, respectively. Z = $300X + $600 Y Total contribution margin This equation is called the objective function, the function to be optimized.

3 Linear Programming Internal constraints: External constraints: Basic Concepts of Constrained Optimization OBJECTIVE 3 Linear Programming Internal constraints: X + Y  80 X + 3Y  120 2X + Y  90 External constraints: X  60 Y  100

3 Linear Programming Basic Concepts of Constrained Optimization OBJECTIVE 3 Linear Programming X + Y  80 X + 3Y  120 2X + Y  90 X  60 Y  100 X  0 Y  0

Basic Concepts of Constrained Optimization OBJECTIVE 3 Graphical Solution 160 140 120 100 80 60 40 20 X  60 Y  100 2X + Y  90 X + Y  80 B C X + 3Y  120 A D 20 40 60 80 100 120 140

C is the optimal solution! Basic Concepts of Constrained Optimization OBJECTIVE 3 Linear Programming Corner Point X-Value Y-Value Z = $300X + $600Y A 0 0 $ 0 B 0 40 24,000 C 30 30 27,000 D 45 0 13,500 C is the optimal solution!

4 Three Measures of Systems Performance: Throughput Inventory Theory of Constraints OBJECTIVE 4 Three Measures of Systems Performance: (Sales revenue – Unit-level variable expenses)/Time Throughput Inventory Operating expenses 17

Five-Step Method for Improving Performance Theory of Constraints OBJECTIVE 4 Five-Step Method for Improving Performance 1. Identify an organization’s constraints. 2. Exploit the binding constraints. 3. Subordinate everything else to the decisions made in Step 2. 4. Elevate the organization’s binding constraints. 5. Repeat the process as a new constraint emerges to limit output. 18

Drum-Buffer-Rope System: General Description Theory of Constraints OBJECTIVE 4 Drum-Buffer-Rope System: General Description Continued from left Continued

Drum-Buffer-Rope System: Schaller Company Theory of Constraints OBJECTIVE 4 Drum-Buffer-Rope System: Schaller Company

New Constraint Set: Schaller Company Theory of Constraints OBJECTIVE 4 New Constraint Set: Schaller Company

End of Chapter 21