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

KHALID AZIZ JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.

KHALID AZIZ JOIN KHALID AZIZ FRESH CLASSES FRESH CLASSES ICMAP STAGE 1 & 2 ICMAP STAGE 1 & 2 FUNDAMENTALS OF FINANCIAL ACCOUNTING & COST ACCOUNTING FUNDAMENTALS OF FINANCIAL ACCOUNTING & COST ACCOUNTING INDIVIDUAL & GROUPS INDIVIDUAL & GROUPS

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

KHALID AZIZ Costs Associated with Goods for Sale 1. Purchasing costs include transportation costs. 2. Ordering costs include receiving and inspecting the items in the orders. 3. Carrying costs include the opportunity cost of the investment tied up in inventory and the costs associated with storage.

KHALID AZIZ Costs Associated with Goods for Sale 4. Stockout costs occur when an organization runs out of a particular item for which there is a customer demand. 5. Quality costs of a product or service is its lack of conformance with a prespecified standard.

KHALID AZIZ Learning Objective 2 Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model.

KHALID AZIZ Economic-Order-Quantity Decision Model Assumptions 1. The same quantity is ordered at each reorder point. 2. Demand, ordering costs, carrying costs, and purchase-order lead time are known with certainty. 3. Purchasing costs per unit are unaffected by the quantity ordered.

KHALID AZIZ Economic-Order-Quantity Decision Model Assumptions 4. No stockouts occur. 5. Quality costs are considered only to the extent that these costs affect ordering costs or carrying costs.

KHALID AZIZ Economic-Order-Quantity Decision Model Assumptions The EOQ minimizes the relevant ordering costs and carrying costs. Video store sells packages of blank video tapes. Video purchases packages of video tapes from Oaks, Inc., at Rs.15/package.

KHALID AZIZ Economic-Order-Quantity Decision Model Assumptions Annual demand is 12,844 packages, at the rate of 247 packages per week. Video requires a 15% annual return on investment. The purchase-order lead time is two weeks. What is the economic-order-quantity?

KHALID AZIZ Economic-Order-Quantity Decision Model Assumptions Relevant ordering cost per purchase order: Rs.209 Relevant carrying costs per package per year: Required annual ROI (15% × Rs.15)Rs.2.25 Relevant other costs 3.25 TotalRs.5.50

KHALID AZIZ Economic-Order-Quantity Decision Model Example 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

KHALID AZIZ Economic-Order-Quantity Decision Model Example = 988 packages EOQ =

KHALID AZIZ Economic-Order-Quantity Decision Model Example What are the relevant total costs (RTC)? RTC = Annual relevant ordering costs + Annual relevant carrying costs RTC = Q can be any order quantity, not just the EOQ. DQDQ ×P+ Q2Q2 C× DP Q + QC 2 or

KHALID AZIZ Economic-Order-Quantity Decision Model Example When Q = 988 units, RTC = (12,844 × Rs.209 ÷ 988) + (988 × Rs.5.50 ÷ 2) = Rs.5,434 total relevant costs How many deliveries should occur each time period? D EOQ 12, ==13 deliveries

KHALID AZIZ JOIN KHALID AZIZ FRESH CLASSES FRESH CLASSES MA-ECONOMICS MA-ECONOMICS MICRO, Macro & STATISTICS MICRO, Macro & STATISTICS INDIVIDUAL & GROUPS INDIVIDUAL & GROUPS

Economic-Order-Quantity Decision Model Example Relevant Total Costs (Dollars) 2,000 4,000 6,000 8,000 10,000 5, ,2001,800 2, EOQ Annual relevant carrying costs Annual relevant total costs Annual relevant ordering costs Order Quantity (Units)

KHALID AZIZ Reorder Point Reorder point = Number of units sold per unit of time × Purchase-order lead time EOQ = 988 packages Number of units sold/week = 247 Purchase-order lead time = 2 weeks Reorder point = 247 × 2 = 494 packages

Reorder Point Weeks Reorder Point This exhibit assumes that demand and purchase-order lead time are certain: Demand = 247 tape packages/week Purchase-order lead time = 2 weeks Lead Time 2 weeks Lead Time 2 weeks

KHALID AZIZ Safety Stock Example Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. Video’s expected demand is 247 packages per week. Management feels that a maximum demand of 350 packages per week may occur.

KHALID AZIZ Safety Stock Example How much safety stock should be carried? 350 Maximum demand – 247 Expected demand = 103 Excess demand per week 103 packages × 2 weeks lead time = 206 packages of safety stock.

KHALID AZIZ Considerations in Obtaining Estimates of Relevant Costs What are the relevant incremental costs of carrying inventory? – only those costs of the purchasing company that change with the quantity of inventory held

KHALID AZIZ Cost of Prediction Error Predicting relevant costs requires care and is difficult. Assume that Video’s relevant ordering cost is Rs instead of the Rs.209 prediction used. What is the cost of this prediction error?

KHALID AZIZ Cost of Prediction Error EOQ = Step 1: Compute the monetary outcome from the best action that could have been taken, given the actual amount of the cost input. = 676 packages

KHALID AZIZ Cost of Prediction Error The annual relevant total costs when EOQ is 676 packages is: RTC = DP Q + QC 2 RTC = (12,844 × Rs ÷ 676) + (676 × Rs.5.50 ÷ 2) = Rs.3,718 total relevant costs

KHALID AZIZ Cost of Prediction Error Step 2: Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost input. EOQ == 988 packages

KHALID AZIZ Cost of Prediction Error What are the annual relevant costs using this order quantity when D = 12,844 units, P = Rs.97.84, and C = Rs.5.50? RTC = (12,844 × Rs ÷ 988) + (988 × Rs.5.50 ÷ 2) = Rs. 3,989 total relevant costs

KHALID AZIZ Cost of Prediction Error Step 3: Compute the difference between the monetary outcomes from Steps 1 & 2. Step 1Rs.3,718 Step 2 3,989 DifferenceRs. (271) The cost of prediction error is Rs.271.

KHALID AZIZ Learning Objective 3 Identify and reduce conflicts that can arise between EOQ decision model and models used for performance evaluation.

KHALID AZIZ 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.

KHALID AZIZ 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. 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.

KHALID AZIZ 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.

KHALID AZIZ JIT Purchasing and EOQ Model Parameters 2. Companies are using electronic links, 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).

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

KHALID AZIZ 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. “bullwhip effect” or “whiplash effect”

KHALID AZIZ JOIN KHALID AZIZ FRESH CLASSES FRESH CLASSES ICMAP STAGE 1 & 2 ICMAP STAGE 1 & 2 FUNDAMENTALS OF FINANCIAL ACCOUNTING & COST ACCOUNTING FUNDAMENTALS OF FINANCIAL ACCOUNTING & COST ACCOUNTING INDIVIDUAL & GROUPS INDIVIDUAL & GROUPS

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

KHALID AZIZ 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.

KHALID AZIZ Materials Requirement Planning (MRP) 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, the downtime costs, and carrying costs of inventory.

KHALID AZIZ Learning Objective 6 Identify the features of a just-in-time production system.

KHALID AZIZ 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.

KHALID AZIZ Major Features of a JIT System 1. Organizing production in manufacturing cells 2. Hiring and retaining multi-skilled workers 3. Emphasizing total quality management 4. Reducing manufacturing lead time and setup time 5. Building strong supplier relationships

KHALID AZIZ Major Features of a JIT System What information may management accountants use? Personal observation by production line workers and managers Financial performance measures, such as inventory turnover ratios Nonfinancial performance measures of time, inventory, and quality.

KHALID AZIZ Learning Objective 7 Use backflush costing.

KHALID AZIZ 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.

KHALID AZIZ 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.

KHALID AZIZ Learning Objective 8 Describe different ways backflush costing can simplify traditional job-costing systems.

KHALID AZIZ 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.

KHALID AZIZ Trigger Points Stage A: Purchase of direct materials Stage B: Production resulting in work in process Stage C: Completion of good units of product Stage D: Sale of finished goods

KHALID AZIZ Trigger Points Assume trigger points A, C, and D. This company would have two inventory accounts: Type 1. Combined materials and materials in work in process inventory 2. Finished goods Account Title 1. Inventory: Raw and In-process Control 2. Finished Goods Control

KHALID AZIZ Trigger Points What is the journal entry when trigger point A occurs? Inventory: Raw and In-process ControlXX Accounts Payable ControlXX To record direct material purchased during the period

KHALID AZIZ Trigger Points What is the journal entry to record conversion costs? Conversion Costs ControlXX Various accountsXX To record the incurrence of conversion costs during the accounting period Underallocated or overallocated conversion costs are written off to cost of goods sold.

KHALID AZIZ Trigger Points What is the journal entry when trigger point C occurs? Finished Goods ControlXX Inventory: Raw and In-Process ControlXX Conversion Costs AllocatedXX To record the cost of goods completed during the accounting period

KHALID AZIZ Trigger Points What is the journal entry when trigger point D occurs? Cost of Goods SoldXX Finished Goods ControlXX To record the cost of goods sold during the accounting period

KHALID AZIZ Trigger Points Assume trigger points A and D. This company would have one inventory account: Type Combines direct materials inventory and any direct materials in work in process and finished goods inventories Account Title Inventory Control

KHALID AZIZ Trigger Points What is the journal entry when trigger point A occurs? Inventory: Raw and In-process Control XX Accounts Payable ControlXX To record direct material purchased during the period Same as the A, C, and D example.

KHALID AZIZ Trigger Points What is the journal entry to record conversion costs? Conversion Costs ControlXX Various accountsXX To record the incurrence of conversion costs during the accounting period Same as the A, C, and D example.

KHALID AZIZ Trigger Points What is the journal entry to record the cost of goods completed during the accounting period (trigger point C)? No journal entry.

KHALID AZIZ Trigger Points What is the journal entry when trigger point D occurs? Cost of Goods SoldXX Inventory ControlXX Conversion Costs AllocatedXX To record the cost of goods sold during the accounting period

KHALID AZIZ JOIN KHALID AZIZ ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. CONTACT: CONTACT: R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.