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Inventory Management,

Just-in-Time, and
Backflush Costing
Chapter 20

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Learning Objective 1

Identify five categories of costs


associated with goods for sale.

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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.

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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.

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Learning Objective 2

Balance ordering costs with


carrying costs using the
economic-order-quantity
(EOQ) decision model.

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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 i.e. no discounts

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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.

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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 $15/package.

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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?

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Economic-Order-Quantity
Decision Model Assumptions

Relevant ordering cost per purchase order: $209


Relevant carrying costs per package per year:
Required annual ROI (15% × $15) $2.25
Relevant other costs 3.25
Total $5.50

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Economic-Order-Quantity
Decision Model Example

2 DP
EOQ =
C

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

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Economic-Order-Quantity
Decision Model Example

2x128
, 44x$209
EOQ =
$5 .50

976,144 = 988 packages

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Economic-Order-Quantity
Decision Model Example

What are the relevant total costs (RTC)?


RTC = Annual relevant ordering costs
+ Annual relevant carrying costs
D Q DP QC
RTC = Q × P + 2 × C or Q + 2

Q can be any order quantity, not just the EOQ.


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Economic-Order-Quantity
Decision Model Example

When Q = 988 units,


RTC = (12,844 × $209 ÷ 988) + (988 × $5.50 ÷ 2)
= $5,434 total relevant costs
How many deliveries should occur each time period?

D 12,844
EOQ = 988 = 13 deliveries

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Economic-Order-Quantity
10,000
Decision Model Example
Relevant Total Costs (Dollars)

8,000
Annual relevant
total costs

6,000
5,434

4,000 Annual relevant


ordering costs
Annual relevant
carrying costs
2,000

600 988 1,200 1,800 2,400


Order Quantity (Units) EOQ 20 - 15
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

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Reorder Point
988

Reorder Reorder
Point Point

494

Weeks 1 2 3 4 5 6 7 8
Lead Time Lead Time
2 weeks 2 weeks

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

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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.

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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

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Cost of Prediction Error

Predicting relevant costs requires care


and is difficult.
Assume that Video’s relevant ordering cost
is $97.84 instead of the $209 prediction used.
What is the cost of this prediction error?

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Cost of Prediction Error

Step 1: Compute the monetary outcome


from the best action that could have been
taken, given the actual amount of the cost input.

2x128
, 44x978
.4
EOQ =
$5.50

EOQ = 456,966= 676 packages


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Cost of Prediction Error

The annual relevant total costs when EOQ is


676 packages is:

DP QC
RTC = +
Q 2

RTC = (12,844 × $97.84 ÷ 676) + (676 × $5.50 ÷ 2)


= $3,718 total relevant costs
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Cost of Prediction Error

Step 2: Compute the monetary outcome


from the best action based on the incorrect
amount of the predicted cost input.

2x128
, 44x$209
EOQ = = 988 packages
$5.50

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Cost of Prediction Error

What are the annual relevant costs using


this order quantity when
D = 12,844 units, P = $97.84, and C = $5.50?
RTC = (12,844 × $97.84 ÷ 988) + (988 × $5.50 ÷ 2)
= $ 3,989 total relevant costs

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Cost of Prediction Error

Step 3: Compute the difference between


the monetary outcomes from Steps 1 & 2.
Step 1 $3,718
Step 2 3,989
Difference $ (271)
The cost of prediction error is $271.

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Learning Objective 3

Identify and reduce conflicts


that can arise between EOQ
decision model and models used
for performance evaluation.

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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.

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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.
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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.
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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).

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Learning Objective 4

Use a supply-chain approach


to inventory management.

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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.

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Learning Objective 5

Differentiate materials
requirements planning (MRP)
systems from just-in-time (JIT)
systems for manufacturing.

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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.

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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.
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Learning Objective 6

Identify the features of a


just-in-time production system.

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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.

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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

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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.
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Learning Objective 7

Use backflush costing.

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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.

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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.

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Learning Objective 8

Describe different ways


backflush costing can simplify
traditional job-costing systems.

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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.

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Trigger Points

Stage A: Stage B:
Purchase of Production resulting
direct materials in work in process

Stage C: Stage D:
Completion of good Sale of
units of product finished goods
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Trigger Points

Assume trigger points A, C, and D.


This company would have two inventory accounts:

Type Account Title


1. Combined materials 1. Inventory:
and materials in work Raw and In-process
in process inventory Control
2. Finished goods 2. Finished Goods Control
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Trigger Points

What is the journal entry when trigger point A occurs?


Inventory: Raw and In-process Control XX
Accounts Payable Control XX
To record direct material purchased during the period

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Trigger Points

What is the journal entry to record conversion costs?


Conversion Costs Control XX
Various accounts XX
To record the incurrence of conversion costs during
the accounting period
Underallocated or overallocated conversion costs
are written off to cost of goods sold.
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Trigger Points

What is the journal entry when trigger point C occurs?


Finished Goods Control XX
Inventory: Raw and
In-Process Control XX
Conversion Costs Allocated XX
To record the cost of goods completed during the
accounting period
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Trigger Points

What is the journal entry when trigger point D occurs?


Cost of Goods Sold XX
Finished Goods Control XX
To record the cost of goods sold during the
accounting period

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Trigger Points

Assume trigger points A and D.


This company would have one inventory account:

Type Account Title


Combines direct materials
inventory and any direct Inventory Control
materials in work in process
and finished goods inventories
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Trigger Points

What is the journal entry when trigger point A occurs?


Inventory: Raw and In-process Control XX
Accounts Payable Control XX
To record direct material purchased during the period
Same as the A, C, and D example.

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Trigger Points

What is the journal entry to record conversion costs?


Conversion Costs Control XX
Various accounts XX
To record the incurrence of conversion costs during
the accounting period
Same as the A, C, and D example.

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

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Trigger Points

What is the journal entry when trigger point D occurs?


Cost of Goods Sold XX
Inventory Control XX
Conversion Costs Allocated XX
To record the cost of goods sold during the
accounting period

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End of Chapter 20

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