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.
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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.