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

CHAPTER 20

INVENTORY MANAGEMENT, JUST-IN-TIME, AND BACKFLUSH COSTING

LEARNING OBJECTIVES

1. Identify five categories of costs associated with goods for sale

1. Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model

1. Identify and reduce conflicts that can arise between EOQ decision model and models used for performance evaluation

1. Use a supply-chain approach to inventory management

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

1. Identify the features of a just-in-time production system

1. Use backflush costing

1. Describe different ways backflush costing can simplify traditional job-costing systems

CHAPTER OVERVIEW

Chapter 20 looks at a specific aspect of accounting for products—that of inventory. Both the accounting for products from the perspective of the retailer as well as that of the manufacturer are examined. Resources represented by inventory account for the largest cost in many retail companies. Managers understand the effect they have upon profitability. Management accountants provide necessary information for the managing of inventory. Basic types of information are described within the chapter: types of costs associated with inventory, key decisions about managing goods, challenges in estimating costs and their effects, and manufacturing systems to better manage inventory. The two key questions for a retailer for managing inventory are those of how much to order and when to order. These same questions are crucial for a manufacturer but are placed in terms of the supply chain with the manufacturer dependent upon that retailer, causing some differences in how to manage under conditions of uncertainty.

The chapter provides a look at the accounting system for manufacturing products using a just-in-time (JIT) processing system. The manufacturing system is described and the accounting for such a system is detailed using the concept of backflush costing. This study provides another example of how the accounting system describes the underlying operations for the manufacturing of a product. The just-in-time system is compared to the system of materials requirements planning (MRP), a push-through systems as opposed to the demand-pull system of JIT. A section on Enterprise Resource Planning has been added. These systems are examined by their effect(s) on inventories managed by a company.

CHAPTER OUTLINE

1. Inventory management

1. Inventory management: an important part of profit planning for manufacturing and merchandising companies

1. Materials costs often account for more than 40% of total costs in manufacturing companies and more than 70% of total costs in retail companies

1. Inventory management in retail organizations

1. Inventory management: the planning, coordinating, and control activities related to the flow of inventory into, through, and from an organization

1. Costs of goods sold is largest single cost item for some retailers

1. Better decisions regarding the purchasing and managing of goods for sale can cause large percentage increases in net income when net income is small percentage of revenues

1. Costs associated with goods for sale

Learning Objective 1:

Identify five categories of costs associated with goods for sale

1. Purchasing costs: costs of goods acquired from suppliers including incoming freight or transportation costs

1. Usually largest cost category of goods for sale

1. Affected by discounts for different purchase-order sizes and supplier credit terms

1. Ordering costs: include costs of preparing purchase orders and receiving goods

1. Carrying costs: costs of holding inventory of goods for sale

1. Include opportunity cost of investment tied up in inventory

1. Include costs associated with storage (space rental, insurance, obsolescence, spoilage)

1. Stockout costs: costs arising when a customer demands a unit of product and that unit is not on hand

1. Costs of expediting order from supplier

1. Costs (opportunity costs) of lost contribution margin and customer ill-will

1. Quality costs: costs of product or service not in conformance with a preannounced or prespecified standard

1. Advances in information-gathering technology increasing reliability and timeliness

1. Increasing reliability and timeliness of inventory information

1. Reducing costs in the five cost categories

Do multiple choice 1.Assignment after L. O. 2.

1. Major decisions in managing goods for sale

Learning Objective 2:

Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model

1. How much to order of a given product

1. Economic order quantity (EOQ): decision model that calculates optimal quantity of inventory to order under a set of assumptions (balancing ordering and carrying costs)

1. Same quantity ordered at each reorder point

1. Demand, ordering costs, and carrying costs known with certainty as is purchase-order lead time: time between placing an order and its delivery

1. Purchasing costs unaffected by quantity ordered

1. No stockout occurs

1. Quality costs only considered to extent they affect ordering or carrying costs

1. EOQ formula:

1. D = demand in units for a specified time period

1. P = relevant ordering costs per purchase order

1. C = relevant carrying costs of one unit stock for the time period used for D

1. EOQ increases with demand and ordering costs/decreases with carrying costs

1. Annual relevant total costs (RTC) for any order quantity formula

i. / RTC / = / DQ / x / P / + / Q2 / x / C / = / DPQ / + / QC2 / [Exhibit 20-1]

1. Annual relevant costs at minimum amount where relevant ordering costs and relevant carrying costs are equal (EOQ)

1. When to order, assuming certainty

1. Reorder point

1. Definition: quantity level of the inventory on hand that triggers a new order

1. Formula: Reorder point = Number of units sold per unit of time x Purchase-order lead time [Exhibit 20-2]

1. Safety stock[Exhibit 20-3]

1. Definition: Inventory held at all times regardless of the quantity of inventory ordered using the EOQ model

1. Used as a buffer against unexpected increases in demand, uncertainty about lead time and unavailability of stock from suppliers

1. Computed using demand forecasts—usually based on experience

1. Computed to minimize sum of annual relevant stockout costs and carrying costs

1. Estimating inventory-related costs and their effects

1. Considerations in obtaining estimates of relevant costs

1. Obtaining accurate estimates of the EOQ cost parameters

1. Relevant incremental costs

1. Cost behavior in relation to changes in quantity of inventory held

1. Alternative uses of cost factors, such as space and people

1. Relevant opportunity costs of capital (key input in EOQ decision model)

1. Choice not taken provides basis of opportunity costs

1. Lost contribution margin for missed opportunity

1. Cost of prediction error: when actual relevant costs differ from the estimated relevant cost for decision making

1. Three-step approach to calculation of cost of prediction error

1. Step 1: Compute the monetary outcome from the best action that could be taken, given the actual amount of the cost input

1. Step 2: Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost input

1. Step 3: Compute the difference between the monetary outcomes from steps 1 and 2

b.Square root in EOQ model reduces sensitivity of the ordering decision to errors in predicting its parameters

Learning Objective 3:

Identify and reduce conflicts that can arise between EOQ decision model and models used for performance evaluation

1. Evaluation of managers and goal congruence issues

1. Opportunity cost of investment tied up in inventory a key input in EOQ decision model

1. No opportunity costs recorded in financial accounting system so inconsistency in decision model of EOQ and performance evaluation model using financial accounting numbers

1. Can include opportunity costs when evaluating managers, so EOQ decision model consistent with performance evaluation model

Do multiple choice 2 – 6.Assign Exercises 20-16, 17, 18, 19, 20, and Problems 20-26, 27, 28.

IV.Just-in-time purchasing

1. Definition: purchase of goods or materials so that delivered just as needed for production

1. JIT purchasing and EOQ model parameters

1. EOQ cost parameter—carrying cost

1. Cost of carrying inventory considered by some to be underestimated in the past

1. Opportunity costs of investment tied up in inventory to be considered

1. EOQ cost parameter—placing a purchase order

1. Reduction in cost due to long-run purchasing arrangements defining price and quality terms over an extended period

1. Reduction in cost due to using electronic links to place purchase orders

1. Reduction in cost due to use of purchase order cards that do not require traditional labor-intensive procurement approval mechanisms

1. EOQ—combination of relevant carrying costs increasing and relevant ordering costs per purchase order decreasing [Exhibit 20-4]

1. Smaller EOQ amounts (size of order)

1. More frequent orders

1. Relevant benefits and relevant costs of JIT purchasing

1. Compared to EOQ model

1. EOQ model designed to only emphasize trade-off between carrying costs and ordering costs

1. Inventory management includes purchasing costs, stockout costs, and quality costs

1. Illustrated by comparison of traditional policy with JIT purchasing [Exhibit 20-5]

1. Supplier evaluation and relevant costs of quality and timely deliveries

1. Timely delivery of quality product crucial to JIT purchasing

1. Selection and development of long-run supplier partnerships

1. Consideration of relevant costs of quality and also the relevant costs of failing to deliver on time

1. Sales of high-quality merchandise has nonfinancial and qualitative benefits

1. Illustration to compare suppliers: issues and concerns [Exhibit 20-6]

Assign Exercises 20-21 and 20-22 and Problems 20-29 and 20-30.

IV.Inventory management and supply-chain analysis [Surveys of Company Practice]

Learning Objective 4:

Use a supply-chain approach to inventory management

A.Level of inventories held by retailers influenced by demand patterns of customers and supply relationships with distributors, manufacturers, and suppliers to suppliers and so on

1. Flow of goods, services, and information from initial sources of materials and services to delivery of products to consumers—supply chain [Chapter 1, “Enhancing the Value of Management Accounting Systems,” Exhibit 1-5]

1. Variability of demand quantities throughout supply chain called “bullwhip effect” or “whiplash effect” and, consequently, higher levels of inventory held at all stages in supply chain

1. Supply chain approach allows companies to coordinate their activities and reduce inventories through the supply chain—some companies have supplier or vendor-managed inventory

B.Inventory management and manufacturing companies

Assign Problems 20-31 and 20-32.

Learning Objective 5:

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

1. Materials requirement planning (MRP)

1. Definition: a “push-through” system that manufactures finished goods for inventory on the basis of demand forecasts

1. Inputs for MRP

• Master production schedule—demand forecasts for final products taking into account specifics of quantity and timing of each item to be produced

• Bill of materials—detailing of materials, components, and subassemblies for each final product

• Inventory records—quantities of materials, components, and product inventories to determine the necessary outputs at each stage of production

1. Output of each department pushed through the production line whether it is needed or not

1. Result of push-through approach may be accumulation of inventory at workstations not yet ready to process next group

1. Challenge in MRP system is inventory management

1. Management accountant aids in MRP by maintaining accurate records of inventory and its costs

1. Management accountant also helps in estimates of setup cost for production lines

• Costs of setting up a production run analogous to ordering costs in EOQ model

• Costs of setting up matched with size of batches to balance costs of setups with costs of carrying inventory (large costs, large batch sizes or small costs, small batch sizes)

• Costs of downtime matched with running time of production line (high downtime costs, continuous production)

1. Just-in-time (JIT) production (also called lean manufacturing production)

1. Definition: a “demand-pull” manufacturing system because each component in a production line is produced as soon as and only when needed by the next step in the production line

1. Demand triggers each step of the production process, starting with customer demand for finished product at the end of process and working all way back to demand for direct materials at beginning of process

1. Demand-pull feature achieves close coordination among workstations in the process

1. Aims to simultaneously achieve three effects

• Meet customer demand in a timely way,

• With high quality products, and

• At the lowest possible total cost.

Learning Objective 6:

Identify the features of a just-in-time production system

1. Five main features in JIT production system [Concepts in Action]

1. Organizing production in manufacturing cells: grouping of all different types of equipment used to make a product

1. Hiring and training multi-skilled workers

1. Emphasizing total quality management

1. Reducing manufacturing lead time and setup time

1. Building strong supplier relationships

1. Enterprise resource planning (ERP) systems

1. Comprises a single database that collects and feeds data into applications supporting all of a company’s business activities

1. Responds to changes in supply and demand because operating information accessible within the company and across the supply chain

1. Available as standard software packages that can be customized—without customization strategic advantage may not be available

1. Financial benefits of JIT and relevant costs

1. Lower carrying costs of inventory due to lower inventories

1. Greater transparency of production process

1. Heightened emphasis on eliminating specific causes of rework, scrap, and waste

1. Lower manufacturing lead time

1. Performance measures and control in JIT production

1. Personal observation timely, intuitive, and easy to understand measure of plant performance

1. Financial performance measures

1. Nonfinancial performance measures of time, inventory, and quality

1. Feedback that is rapid and meaningful necessary to detect and solve problems quickly due to lack of buffer from inventories

Do multiple choice 7.

1. JIT’s effect on costing systems

1. Reduces overhead costs

1. Facilitates direct tracing of some costs usually classified as indirect

1. Backflush costing: job costing system that dovetails with JIT production

Learning Objective 7:

Use backflush costing

1. Backflush costing: costing system that omits recording some or all of the journal entries relating to the cycle from purchase of direct materials to the sale of finished goods

1. Absence of inventories makes unimportant choices about cost-flow assumptions or inventory costing methods important

1. Rapid conversion of direct materials into finished goods that are immediately sold simplifies job costing; JIT production leads to large reduction in work in process

Learning Objective 8:

Describe different ways backflush costing can simplify traditional job-costing systems

1. Simplified normal or standard job costing

1. Traditional systems use sequential tracking to track costs sequentially as products pass through four stages in a cycle going from purchase of direct materials to sale of finished goods

1. Stage A: Purchase of direct materials

1. Stage B: Production resulting in work in process

1. Stage C: Completion of a good finished unit of product

1. Stage D: Sale of a finished good

1. Trigger point: refers to a stage in the cycle going from purchase of direct material (Stage A) to sale of finished goods (Stage D) at which journal entries are made in the accounting system

1. Examples to illustrate backflush costing

1. Assumptions of no direct materials variances and no work in process

1. Examples differ in number and placement of trigger points

1. Three examples from text

1. Example 1 with three trigger points [Exhibits 20-7 and 8, Panel A]

• Stage A: Purchase of direct materials (raw materials)

• Stage C: Completion of good finished units of product

• Stage D: Sale of finished goods

1. Example 2 with two trigger points [Exhibits 20-7 and 8, Panel B]

• Stage A: Purchase of direct materials (raw materials){only inventory account}

• Stage D: Sale of finished goods

1. Example 3 with two trigger points [Exhibits 20-7 and 8, Panel C]

• Stage C: Completion of goods finished units of product

• Stage D: Sale of finished goods

1. Examples to illustrate backflush costing: comparison to sequential tracking

1. Example 1: Costs reported similarly to sequential tracking when WIP minimal

1. Two inventory accounts: (1) Materials and In-Process and (2) Finished Goods

1. Actual conversion costs recorded in Conversion Costs (allocated to products at trigger points)

1. Steps to assign costs to units sold and to inventories

• Step 1: Record the direct materials purchased during the accounting period

• Step 2: Record conversion costs incurred during the accounting period

• Step 3: Determine the number of good finished units manufactured during the accounting period

• Step 4: Compute the normal or standard costs per finished unit

• Step 5: Record the cost of good finished goods completed during the accounting period

Name—backflush costing—comes from this step

Costs not recorded sequentially with flow of product through production

Output trigger point reaches back and pulls standard costs into entry

• Step 6: Record the cost of goods sold during the accounting period

• Step 7: Record underallocated or overallocated conversion costs

1. Accounting for variances—basically same under all standard costing systems

1. Example 2: Costs reported similarly to sequential tracking when WIP and finished goods minimal

1. One inventory account: Inventory—combines direct materials and any direct materials in WIP and finished goods

1. Conversion costs treated as period costs, not inventoried

1. Accounting justified for two reasons

• To remove incentive for managers to produce for inventory

• To increase focus of managers on selling units

1. Example 3: Costs reported similarly to sequential tracking when direct materials and WIP minimal

1. Could be used with only one trigger point—Stage D: Sale of finished goods

ii.Could be used with only one trigger point—Stage D: Sale of finished goods—maintains no inventory accounts so used with JIT system with minimal inventories