chapter 11 controlling inventory and production costs

Chapter 11

Controlling Inventory and Production Costs

1. Why do managers use ABC inventory control

systems?

2. How does a company determine from whom,

how much, and when to order?

C11

Learning Objectives

3. What are the differences between the economic order

quantity model and materials requirements

planning?

4. What is the JIT philosophy and how does it affect

production?

C11

Continuing . . . Learning Objectives

5. What is the impact of flexible manufacturing systems on

production and on satisfying customers?

6. How would the traditional accounting system change if a

JIT inventory system were adopted? (Appendices 1 and

2)

C11

Continuing . . . Learning Objectives

7. How does the product life cycle influence sales

and costs? (Appendix 3)

C11

Continuing . . . Learning Objectives

Costs Associated with Inventory:

Purchasing or Production

Purchasing Production

$$$

Quoted price Direct material

- Discounts allowed + Direct labor

+ Shipping charges +Traceable overhead

+ Insurance charges +Allocated fixed overhead

while items are

in transit

Costs Associated with Inventory:

Ordering or Setup

Ordering SetupInvoice preparation Labor time

receipt & inspection Machine downtime

Payment

Forms

Clerical processing

12

3

6

9

Costs Associated with Inventory:

Carrying or Not Carrying (Stockout)

Carrying Not Carrying

(Stockout)Storage Lost customer goodwillHandling Lost contribution marginInsurance charges Ordering & shipping Property taxes charges from filling Losses from obsolescence, special orders damage, and theft Setup costs for rescheduledOpportunity cost of production invested capital

Decisions in Purchasing Inventory

In purchasing inventory, a purchasing manager needs to make three primary decisions.

– What supplier?

– What quantity?

– When to order?

Traditional Supplier Relationship

Decision based primarily on price!

$

Partnership View

of New Buyer-Supplier Relations

Views cost in relationto quality and reliability

Changes in

Buyer-Supplier Relationship• Number of vendors reduced to limited group

– Selected based on quality, reliability, price

– Quality certification

• Long-term contracts

• Develop better communications– Site visits

• Assure quality and service

• Obtain quantity discounts– Order size reduced

– Frequency of delivery increased

• Reduce operating costs

Economic Order Quantity

Estimate of number of units per order that

would provide the optimal balance between

ordering and carrying costs

AFTER

the supplier

is selected EOQ = 2 Q O

C

Example

Quantity needed per year (Q) = 4,200 tons

Cost of ordering (O) = $30 per order

Cost of carrying (C) = $10 per ton

Uses 15 tons of pulp wood per day

Supplier can deliver in 3 days

Maximum quantity used per day is 19 tons

Economic Order Quantity

EOQ =2 Q O

C

EOQ =

EOQ =

2 (4,200) $30

$10

159 (rounded)

Total Inventory Costs

Carrying Costs:

(159 2) x $10 = $ 795

Ordering Costs:

(4,200 159) x $30 792

Total Inventory Costs $1,587=====

Questions to Ask Before Ordering

• Is storage space a limited resource?• How critical is the item to production?• How critical is cash flow?• Can units be ordered in the quantity indicated?

When to Order

Safety Stock = (Maximum Usage - Normal Usage) x Lead Time

= ( 19 - 15) x 3 = 12 tons

Order Point = (Daily Usage x Lead Time) + Safety Stock

= ( 15 x 3) + 12 = 57 tons

Problems with EOQ Model

• Is difficult to identify all relevant inventory costs

• Does not provide any direction for managers attempting to control individual types of purchasing and carrying costs

• Ignores relationships among inventory items

Materials Requirements Planning

• What items are needed?• How many of them are needed?• When are they needed?

Answers the questions:

Steps in an MRP System

• Sales forecast used to develop a master production schedule (MPS)

• Computer MRP model generates a time-sequenced schedule for purchases and production component needs using

– Product bill of materials and operations flow document

– Inventory balances

– Lead time

Continuing . . . Steps in

an MRP System

Work load compared with capacity; bottlenecks identified

– MRP program run again until all bottlenecks accounted for

MRP II

Manufacturing Resource Planning

Plans production jobs using MRP AND

calculates resource needssuch as labor and machine hours

Involves manufacturing, marketing, and finance

Push System

MaterialsStorage

WIPStorage

FGStorage

Purchases

Sales

WIPStorage

Work

Center

Work

Center

Work

Center

Just-In-Time Systems

• Eliminating any production process or operation that does not add value to the product/service

• Continuously improving production/performance efficiency

• Reducing the total cost of production/performance while increasing quality

Three primary goals

Elements of JIT Philosophy

• Eliminate as much inventory and storage space as possible

• Keep lead time short by using frequent deliveries

• Use creative thinking to find ways to reduce costs

• Work to eliminate defects and scrap

Continuing . . . Elements of

JIT Philosophy

• Establish good relationships with suppliers • Listen to employees• Train employees to be multiskilled and increase

productivity• Constantly look for ways to improve operations

Pull System

Purchases

Sales

WorkCenter

WorkCenter

WorkCenter

Product Processing

• Reduce machine setup time– New equipment

– Training

• Implement highest quality standards and focus on goal of zero defects

– Quality determined on continuous basis

– Vendor product quality

– Quality in conversion process

– Modern production equipment

Traditional

Manufacturing Plant Layout

WIP

WIPWIPWIP

WIPWIP

Finished

Goods

aterials

M

Just-In-Time

Manufacturing Plant Layout

Finished

Goods

aterials

M

Employee Empowerment• Put the right people in the right jobs

• Make training an ongoing process

• Provide employees with necessary tools

– Equipment

– Information

– Authority

– Training

• Push decision-making authority and responsibility down to lowest reasonable level

• Establish atmosphere of trust among all employees at all levels

Seven Steps to Implement

a JIT System

1. Determine how well products, materials, or services are delivered now.

2. Determine how customers define superior service, and set priorities accordingly.

3. Establish specific priorities for distribution (and possibly purchasing) functions to meet customer needs.

4. Collaborate with and educate managers and employees to refine objectives and to prepare for implementation of JIT.

Continuing . . . Seven Steps to

Implement a JIT System

5.Execute a pilot implementation project and evaluate its results.

6.Refine the JIT delivery program and execute it company wide.

7.Monitor progress, adjust objectives over time, and always strive for excellence.

Important Relationships

Every company has a set of upstream suppliers and a set of downstream customers. In a one-on-one context, these parties can be depicted in the following model:

UpstreamSupplier

The CompanyDownstream

Customer

Continuing . . .

Important Relationships

Consider the following opportunities for improvement between entities:

• improved communication of requirements and specifications

• greater clarity in requests for products or services

• improved feedback regarding unsatisfactory products or services

• improvements in planning, controlling, and problem solving

• shared managerial and technical expertise, supervision, and training

Flexible Manufacturing Systems

A flexible manufacturing system (FMS) is a network of robots and material conveyance devices monitored and controlled by computers.

Two or more FMSs connected by a host computer and an information networking system are generally referred to as computer integrated manufacturing (CIM).

Comparison of Traditional

Manufacturing and FMS

Information requirements Batch-based On-line, real-time

Product variety Low Basically unlimited

Response time to market needs Slow Rapid

Worker tasks Specialized Diverse

Production runs Long Short

Lot sizes Massive Small

FACTOR MANUFACTURING FMS TRADITIONAL

Continuing . . . Comparison of

Traditional Manufacturing and FMS

Basis of performance rewards Individual Team

Setups Slow and expensive Fast and inexpensive

Product life cycle expectation Long Short

Work area control Centralized Decentralized

Technology Labor-intensive Technology- intensive

Worker knowledge of technology Low to medium Highly trained

FACTOR MANUFACTURING FMS TRADITIONAL

Accounting Implications of JIT

• End-of-period variance reporting and analysis essentially disappears– Variances recognized on the spot

• Two comparison standards: annual and current• Use conversion costs rather than labor and

overhead• Inventory accounting

– Raw and In Process (RIP) Inventory account

Backflush Costing

• Streamlined cost accounting method that speeds up, simplifies, and reduces accounting effort

• During period, records purchases of materials and accumulates conversion costs

• At completion or sale, total costs incurred recorded to cost of goods sold and finished goods inventory using standard production costs

Continuing . . . Backflush Costing

Bernard Company’s standard production cost per unit:

Direct material $ 75

Conversion 184

Total costs $259====

No beginning inventories exist.

Continuing . . . Backflush Costing

(1):

Raw and In Process Inventory 1,530,000

Accounts Payable 1,530,000

Purchased $1,530,000 of direct materials in June.

Continuing . . . Backflush Costing

(2):

Conversion Costs 3,687,000

Various accounts 3,687,000

Incurred $3,687,000 of conversion costs in June.

Continuing . . . Backflush Costing

(3):

Finished Goods Inventory 5,180,000

Raw and In Process Inventory 1,500,000

Conversion Costs 3,680,000

Completed 20,000 units of production in June.

Continuing . . . Backflush Costing

(4):

Cost of Goods Sold 5,128,200

Finished Goods Inventory 5,128,200

Accounts Receivable 8,316,000

Sales 8,316,000

Sold 19,800 units having a cost of $259 per unit on account in June for $420.

Continuing . . . Backflush Costing

Ending Inventories:

Raw and In Process ($1,530,000 - $1,500,000) $30,000

Finished Goods ($5,180,000 - $5,128,200) 51,800

In addition, there are underapplied conversion costs of $7,000 ($3,687,000 - $3,680,000).