inventory management, just-in-time, and backflush costing

Inventory Management,Just-in-Time, andBackflush Costing

JOIN KHALID AZIZ

•FRESH CLASSES•ICMAP STAGE 3•COST ACCOUNTING PERFORMANCE APPRAISAL

•18TH FEBRUARY 2010•INDIVIDUAL & GROUPS

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• 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.

• CONTACT:• 0322-3385752• 0312-2302870• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

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Learning Objective 1

Identify five categories of costs

associated with goods for sale.

Costs Associated withGoods for Sale

1. Purchasing costs include transportation costs.

2. Ordering costs include receiving andinspecting the items in the orders.

3. Carrying costs include the opportunity costof the investment tied up in inventory andthe costs associated with storage.

Costs Associated withGoods for Sale

4. Stockout costs occur when an organizationruns out of a particular item for whichthere is a customer demand.

5. Quality costs of a product or service is its lackof conformance with a prespecified standard.

Learning Objective 2

Balance ordering costs with

carrying costs using the

economic-order-quantity

(EOQ) decision model.

Economic-Order-QuantityDecision Model Assumptions

1. The same quantity is ordered at eachreorder point.

2. Demand, ordering costs, carrying costs,and purchase-order lead time areknown with certainty.

3. Purchasing costs per unit are unaffectedby the quantity ordered.

JOIN KHALID AZIZ

•FRESH CLASSES•ICMAP STAGE 1•FUNDAMENTALS OF FINANCIAL ACCOUNTING

•18TH FEBRUARY 2010•INDIVIDUAL & GROUPS

Economic-Order-QuantityDecision Model Assumptions

4. No stockouts occur.

5. Quality costs are considered only to theextent that these costs affect orderingcosts or carrying costs.

Economic-Order-QuantityDecision Model Assumptions

The EOQ minimizes the relevant orderingcosts and carrying costs.

Video store sells packages of blank video tapes.

Video purchases packages of video tapes fromOaks, Inc., at Rs15/package.

Economic-Order-QuantityDecision Model Assumptions

Annual demand is 12,844 packages, at therate 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?

Economic-Order-QuantityDecision Model Assumptions

Relevant ordering cost per purchase order: Rs209

Relevant carrying costs per package per year:Required annual ROI (15% × Rs15) Rs2.25Relevant other costs 3.25

Total Rs5.50

Economic-Order-Quantity Decision Model Example

EOQ =2DP

C

D = Demand in units for a specified time period

P = Relevant ordering costs per purchase orderC = Relevant carrying costs of one unit in stock for the time period used for D

Economic-Order-Quantity Decision Model Example

2 12 84450

x x, $209$5.

976 144, = 988 packages

EOQ =

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.

DQ × P +

Q2 C×

DPQ +

QC2or

Economic-Order-Quantity Decision Model Example

When Q = 988 units,

RTC = (12,844 × Rs209 ÷ 988) + (988 × Rs5.50 ÷ 2)= Rs5,434 total relevant costs

How many deliveries should occur each time period?

DEOQ

12,844988= = 13 deliveries

Economic-Order-Quantity Decision Model Example

20 - 15

Rel

evan

t Tot

al C

osts

(D

olla

rs)

2,000

4,000

6,000

8,000

10,000

5,434

600 1,200 1,800 2,400988EOQ

Annual relevant carrying costs

Annual relevant total costs

Annual relevant ordering costs

Order Quantity (Units)

Reorder Point

Reorder point= Number of units sold per unit of time

× Purchase-order lead time

EOQ = 988 packagesNumber of units sold/week = 247

Purchase-order lead time = 2 weeks

Reorder point = 247 × 2 = 494 packages

Reorder PointReorder Point988

494

Weeks 1 2 3 4 5 6 7 8

Reorder Point

Reorder Point

This exhibit assumes that demand and purchase-order lead time are certain:

Demand = 247 tape packages/week Purchase-order lead time = 2 weeks20 - 17

Lead Time2 weeks

Lead Time2 weeks

Safety Stock Example

Safety stock is inventory held at all timesregardless 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 of350 packages per week may occur.

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.

Considerations in ObtainingEstimates of Relevant Costs

What are the relevant incremental costsof carrying inventory?

– only those costs of the purchasing companythat change with the quantity of inventory held

Cost of Prediction Error

Predicting relevant costs requires careand is difficult.

Assume that Video’s relevant ordering costis Rs97.84 instead of the Rs209 prediction used.

What is the cost of this prediction error?

Cost of Prediction Error

456 966,

EOQ =

EOQ =

Step 1: Compute the monetary outcomefrom the best action that could have been

taken, given the actual amount of the cost input.

2 12 844 97 84

50

x x, .

$5.

= 676 packages

Cost of Prediction Error

The annual relevant total costs when EOQ is676 packages is:

RTC =DPQ

+QC2

RTC = (12,844 × Rs97.84 ÷ 676) + (676 × Rs5.50 ÷ 2)= Rs3,718 total relevant costs

Cost of Prediction Error

Step 2: Compute the monetary outcomefrom the best action based on the incorrectamount of the predicted cost input.

EOQ =2 12 844

50x x, $209

$5.= 988 packages

Cost of Prediction Error

What are the annual relevant costs usingthis order quantity when

D = 12,844 units, P = Rs97.84, and C = Rs5.50?

RTC = (12,844 × Rs97.84 ÷ 988) + (988 × Rs5.50 ÷ 2)= Rs 3,989 total relevant costs

Cost of Prediction Error

Step 3: Compute the difference betweenthe monetary outcomes from Steps 1 & 2.

Step 1 Rs3,718Step 2 3,989Difference Rs (271)

The cost of prediction error is Rs271.

Learning Objective 3

Identify and reduce conflicts

that can arise between EOQ

decision model and models used

for performance evaluation.

Evaluating Managers andGoal-Congruence Issues

The opportunity cost of investment tied upin inventory is a key input in the

EOQ decision model.

Some companies now include opportunitycosts as well as actual costs when

evaluating managers.

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• 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.

• CONTACT:• 0322-3385752• 0312-2302870• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

KARACHI, PAKISTAN.

Just-In-Time Purchasing

Just-in-time (JIT) purchasing is the purchaseof goods or materials such that a delivery

immediately precedes demand or use.

Companies moving toward JIT purchasingargue that the cost of carrying inventories(parameter C in the EOQ model) has beendramatically underestimated in the past.

JIT Purchasing and EOQModel Parameters

The cost of placing a purchase order(parameter P in the EOQ model) is

also being re-evaluated.

Three factors are causing sizable reductionin the cost of placing a purchase order (P).

1. Companies increasingly are establishinglong-run purchasing arrangements.

JIT Purchasing and EOQModel Parameters

2. Companies are using electronic links,such as the Internet, to place purchase orders.

3. Companies are increasing the use ofpurchase order cards (similar to consumercredit cards like Visa and Master Card).

Learning Objective 4

Use a supply-chain approach

to inventory management.

Supply-Chain Analysis

Supply-chain analysis describes the flowof goods, services, and information from

cradle to grave, regardless of whetherthose activities occur in the same

organization or other organizations.

“bullwhip effect” or “whiplash effect”

Learning Objective 5

Differentiate materials

requirements planning (MRP)

systems from just-in-time (JIT)

systems for manufacturing.

Materials RequirementPlanning (MRP)

Materials requirements planning (MRP)systems take a “push-through” approach

that manufactures finished goods forinventory on the basis of demand forecasts.

MRP predetermines the necessary outputsat each stage of production.

Materials RequirementPlanning (MRP)

Management accountants play key roles inan MRP system, including...

– maintaining accurate and timely informationpertaining to materials, work in process,

and finished goods, and...

– providing estimates of the setup costs for eachproduction run, the downtime costs,

and carrying costs of inventory.

Learning Objective 6

Identify the features of a

just-in-time production system.

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.

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

Major Features of a JIT System

What information may management accountants use?

Personal observation by productionline workers and managers

Financial performance measures,such as inventory turnover ratios

Nonfinancial performance measuresof time, inventory, and quality.

Learning Objective 7

Use backflush costing.

Backflush Costing

Backflush costing describes a costingsystem that delays recording some orall of the journal entries relating to thecycle from purchase of direct materials

to the sale of finished goods.

Backflush Costing

Where journal entries for one or more stagesin the cycle are omitted, the journal entries

for a subsequent stage use normal or standardcosts to work backward to flush out the costs in

the cycle for which journal entries were not made.

Learning Objective 8

Describe different ways

backflush costing can simplify

traditional job-costing systems.

Trigger Points

The term trigger point refers to a stage in a cyclegoing from purchase of direct materials to saleof finished goods at which journal entries are

made in the accounting system.

JOIN KHALID AZIZ

•FRESH CLASSES•ICMAP STAGE 2•COST ACCOUNTING•18TH FEBRUARY 2010•INDIVIDUAL & GROUPS

Trigger Points

Stage A:Purchase of

direct materials

Stage B:Production resultingin work in process

Stage C:Completion of good

units of product

Stage D:Sale of

finished goods

Trigger Points

Assume trigger points A, C, and D.

This company would have two inventory accounts:

Type1. Combined materials

and materials in workin process inventory

2. Finished goods

Account Title1. Inventory:

Raw and In-processControl

2. Finished Goods Control

Trigger Points

What is the journal entry when trigger point A occurs?

Inventory: Raw and In-process Control XXAccounts Payable Control XX

To record direct material purchased during the period

Trigger Points

What is the journal entry to record conversion costs?

Conversion Costs Control XXVarious accounts XX

To record the incurrence of conversion costs duringthe accounting period

Underallocated or overallocated conversion costsare written off to cost of goods sold.

Trigger Points

What is the journal entry when trigger point C occurs?

Finished Goods Control XXInventory: Raw and In-Process Control XXConversion Costs Allocated XX

To record the cost of goods completed during theaccounting period

Trigger Points

What is the journal entry when trigger point D occurs?

Cost of Goods Sold XXFinished Goods Control XX

To record the cost of goods sold during theaccounting period

Trigger Points

Assume trigger points A and D.

This company would have one inventory account:

TypeCombines direct materialsinventory and any direct

materials in work in processand finished goods inventories

Account Title

Inventory Control

Trigger Points

What is the journal entry when trigger point A occurs?

Inventory: Raw and In-process Control XXAccounts Payable Control XX

To record direct material purchased during the period

Same as the A, C, and D example.

Trigger Points

What is the journal entry to record conversion costs?

Conversion Costs Control XXVarious accounts XX

To record the incurrence of conversion costs duringthe accounting period

Same as the A, C, and D example.

Trigger Points

What is the journal entry to record thecost of goods completed during theaccounting period (trigger point C)?

No journal entry.

Trigger Points

What is the journal entry when trigger point D occurs?

Cost of Goods Sold XXInventory Control XXConversion Costs Allocated XX

To record the cost of goods sold during theaccounting period

JOIN KHALID AZIZ

• ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.

• 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.

• CONTACT:• 0322-3385752• 0312-2302870• R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA,

KARACHI, PAKISTAN.