Management Accounting Fundamentals [MA1]

Module 9: Relevant costs for decision making and

inventory management
Required reading

Chapter 13, pages 616-634

Reading 9-1: "Inventory Decisions"

Reading 9-2: "Reorder Point and Safety Stock"

Overview

This module is devoted to one of the central purposes of managerial accounting: providing information for
decision making. While the subject of decision making has been touched on in other lessons, it provides the
main focus of the reading and study in this module. You will have an opportunity to analyze a relevant cost
situation using a spreadsheet program in Computer illustration 9-1. The topic of economic order quantity
(EOQ) is introduced in Topic 9.8.

Learning objectives

9.1 Identify sunk costs and explain why they are not relevant in decision making based on a general rule
for distinguishing between relevant and irrelevant costs, including decisions about whether to keep or
replace old equipment. (Level 1)

9.2 Prepare an analysis showing whether a product line or other organizational segment should be
dropped or retained.(Level 1)

9.3 Explain what is meant by a make or buy decision and prepare a well-organized make or buy analysis.
(Level 1)

9.4 Construct a worksheet to analyze the relevant costs of a decision to retain or close a store. (Level 1)

9.5 Prepare an analysis showing whether a special order should be accepted. (Level 1)

9.6 Make appropriate computations to determine the most profitable utilization of scarce resources.
(Level 2)

9.7 Prepare an analysis showing whether joint products should be sold at the split-off point or processed
further. (Level 1)

9.8 Compute the optimum inventory level and order size.(Level 1)

Module 9: Relevant costs for decision making and inventory management - Content Links

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Required reading

Chapter 13, pages 616-634

Reading 9-1: "Inventory Decisions"

Reading 9-2: "Reorder Point and Safety Stock"

9.1 Cost concepts for decision making

LEVEL 1

Decision making is a complex activity involving many different factors. In this module, you consider short-
run decisions. The term "short run" implies that the time of payoff is short enough to be able to safely ignore
the time value of money.

Relevant costs are the key to decision analysis. Sunk costs and non-differential costs can, and usually
should, be ignored because they are irrelevant to decision making.

Future costs that do not differ between alternative situations are not relevant. You must distinguish between
analyzing only differential effects and totally analyzing the new situation. Most of the illustrations in the
textbook correctly suggest a focus on differentials. However, you may find that it is useful and easier to
completely analyze the old and new situations rather than the differentials. Study Exhibit 13-1. A good check
is provided if the difference, as well as the old and new situations, can be analyzed independently.

9.2 Adding and dropping product lines

LEVEL 1

According to economic theory, a product line should be dropped if the differential (marginal) revenue does
not cover the differential (marginal) costs. Note how this basic tenet of microeconomics is applied in
practice. There is a need for qualitative factors as well as the quantitative analysis of the difference in
income.

Notice the complexity introduced by the idea of avoidable fixed costs. Contribution lost (a debit) is
compared to fixed costs avoided (a credit). If a net debit appears, the company will be economically hurt by
dropping the product line, ignoring qualitative factors. Exhibit 13-3 presents both the total and marginal
analysis approaches, so some confusion may be avoided.

"Beware of allocated fixed costs" is a good warning and an important illustration of why arbitrary cost
allocations may create a problem for users of accounting information in their decision making.

Segment margins (Exhibit 13-4) avoid arbitrary allocations and thus help present the merits of a product line.

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However, if space or capacity is a constraint, it may be possible to find a product line that will generate more
segment margin than the ones presently sold. This idea is considered a qualitative factor here but leads to
linear programming analysis, which has a quantitative solution. A second qualitative factor is the interaction
of one product line with another (the "magnet"). This is why loss leaders are used in marketing.

9.3 The make or buy decision

LEVEL 1

Vertical integration is a major strategy consideration in running a business. It entails a make or buy decision.
Notice the qualitative factors that the analysis ignores but the decision maker cannot. If the long run (time
value of money) is introduced some, but not all, of these qualitative factors would be captured. Decision
analysis, by its nature, attempts to narrow the focus to a few variables that can be quantified and it is unlikely
to capture all the relevant aspects of the decision situation. Consequently, the decision maker must take care
in drawing conclusions from such analysis.

Exhibit 13-5 shows a list of common differential costs if alternative uses for the space are ignored, as was
mentioned with the product analysis. The analysis concentrates on the differential costs of making and
buying. The result is computed by taking the difference. Opportunity costs are used to consider the effect of
alternative use of the space. Opportunity cost, as used here, refers to the differential gain (segment margin)
foregone by not using the space for the alternative purpose. This lost contribution to income is a differential
cost of producing units because it is an extra cost of using the space.

9.4 Computer illustration 9-1: Relevant costs

LEVEL 1

This computer illustration demonstrates a typical decision analysis used by managers.

Material provided

A partially completed worksheet M9P1

A solution worksheet M9P1S

Required

Solve Requirement 1 of Problem P13-20 (pages 655-656) using the following procedure.

Procedure

1. Open the file MA1M9P1.

2. Study the layout of the worksheet. Rows 6 to 31 have been used as a data table.

3. To save time, column C has been entered for you in the downtown store closure analysis table.
Complete columns D and E of the analysis, using the additional information given in the problem, (a)

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to (g).

4. Save your worksheet.

5. You should obtain a net loss increase of $9,800 if the downtown store is closed. If you do not obtain
this result, print a copy of your worksheet and compare your results with the solution sheet M9P1S.

9.5 Special orders

LEVEL 1

Since a special order is a one-time order that is not expected to become a part of the company's normal
business, the special order is not likely to affect the existing fixed costs for the business. Therefore, the
existing fixed costs should be ignored. The only new costs will be the variable costs and any fixed costs
relating to the new order. These costs should be compared to the projected revenues to determine whether the
special order should be accepted.

9.6 Utilization of a constrained resource

LEVEL 2

Analysis of the utilization of scarce resources can be simple or very complex. In this course, a simple form of
analysis is used. The analysis given in the example uses contribution per unit of constraint (machine-hour)
multiplied by the total constraint capacity to rank the benefits of that alternative. Notice how the idea is
extended to other constraining factors such as advertising or floor space. This analysis is a fundamental tenet
of running a business.

9.7 Joint product costs and the contribution approach

LEVEL 1

Study the definitions of joint product cost and split-off point (Exhibit 13-6). Allocation of the costs for
costing purposes is done on the basis of the relative sales value at the split-off point or the end product point
if no split-off value is available. The allocation is not done for decision purposes.

Whether to sell or process further is the decision problem. In terms of the textbook example, whether to buy
or not to buy the "pig" is a separate question based on the total revenue from the "pig" versus its total cost of
acquisition and processing. To process further, the incremental (differential) revenue from further processing
less the incremental processing costs must be positive. The differential revenue is the ultimate sales price less
the sales price at the split-off point. Exhibit 13-7 illustrates the analysis.

Consider the following problem. The common (joint) cost of a "pig" was allocated on the basis of the relative
sales value of the "cuts" from the "pig." A building is allocated to various products on the basis of the
physical production passing through it; the case is similar for a machine or for service departments. Why?

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Certainly, the cost of a "pig" would not be allocated on the basis of the weight of various "cuts"; yet many
other common costs are so allocated, that is, allocated on the basis of physical inputs or outputs rather than
the relative value of inputs or outputs.

The reason for this common difference in practice is far from obvious. Plantwide as opposed to departmental
overhead allocation is one attempt to get a relative value concept of cost allocation. For example, costing
different meals would also allocate the total cost of a cafeteria based on relative value to producing
departments in a company because departments would be charged differently for different types of meals.

The answer to this problem could lie in the financial accounting concept of materiality and the homogeneity
of the services provided by the common cost. If all meals had the same relative value, physical separation of
the common cost would be adequate. If all meals used the same ingredients, why use a value relationship to
separate the cost? If ingredients or labour differ, we allow for it by using a value relationship.

A joint product with a relatively small value is often termed a by-product. Wood chips, sawdust, and certain
animal parts are common examples. Because of materiality, costs are not allocated to by-products for costing
purposes as they are to joint products. Often, the inventory of by-products is carried in terms of quantities
only, and revenue less costs of disposal (the net realizable value of the by-product) may be credited to cost of
goods sold or cost of goods manufactured, or even overhead in the period when the by-product is sold.

If the inventory of by-products is valued, net realizable value is used and a credit made in the same way as
for sales of regular products. Materiality here permits the rather loose theoretical treatment of by-products.
The decisions with respect to by-products concern the issues of whether they should be sold (possibly
involving disposal costs or even further processing) or simply dumped as waste. The relevant information is
the net realizable value of the by-product plus the cost of waste removal saved by selling the by-product. As
long as this amount is greater than zero, the by-product should be sold. As in joint product decisions, the
common costs are completely irrelevant to the decision.

To conclude your study of relevant costing, read the material on page 634 related to activity-based costing.
Note that activity-based costing does not change the nature of sunk costs just because the costs are traceable
to an activity.

Online chapter summary

This topic marks the end of the textbook coverage of relevant costing. To ensure you understand this
material and the corresponding terminology, read the summary on page 635, work through the review
problems on pages 635-636 and go to the Online Learning Centre, click Contents, choose Chapter 13, select
Chapter Summary and review the material thoroughly. If you are unclear on how to access or use this site,
refer to the Online Learning Centre (OLC) Guide in the course navigation pane.

9.8 Economic order quantity (EOQ) and the reorder point

LEVEL 1

The management of inventory can become very complex and, consequently, very costly. Management
usually begins with an inventory management system that subdivides inventory into categories such as A, B,
and C. Category A represents a small number of items that are very important in terms of value, either cost
or sales. Category B represents a larger number of items that are somewhat less important in total value.
Category C represents the least important items in terms of value but is large in terms of the number of items.

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Most audit textbooks provide a reasonable exposition of how to control items classed as C and perhaps also
those classed as B. This module will concentrate on class A items, (high in value, small in number). This A,
B, C approach is an attempt to determine where increased efforts are likely to pay off.

First note the costs associated with inventories and how they are classified into three groups (Reading 9-1
(To view the content, go to the end of this document.)). Observe that, unlike costs considered relevant for
some of the earlier types of decisions, these costs associated with alternatives for the amount of inventory to
be carried are not isolated in the usual accounting system. The costs must be specifically sought out through
analysis of the accounting records and from other operating information. As usual, some are opportunity
costs.

While the alternatives the decision maker faces are ultimately described in terms of the possible average
levels of inventory to be maintained, that choice is not made directly. Rather, the choice is expressed in terms
of how much to order at a time (or produce in a run). For a given annual demand, this can be translated easily
into the required number of orders per year as well as the frequency of an order. More importantly, it
determines the average amount of inventory on hand.

To begin the analysis, the following cost formula is needed:

T = P (Q/E) + C (E/2)

where:

T = the total of order costs [P(Q/E)] plus the carrying cost of the order while the units are in
inventory [C(E/2)] per period (usually a year); T is a cost for whatever period is represented by
Q, so care must be exercised on how C is specified (that is, it must be for the same period as Q)

P = cost of placing one order (that is, the total ordering costs that are relevant are those directly
variable with the number of orders placed, not the number of units ordered)

C = a constant periodic carrying cost per unit of inventory (that is, relevant total carrying costs
are variable with the number of units ordered)

Q = quantity needed in units for period specified

E = order size in units (what you are trying to find)

E/2 is the average number of units on hand during the period. To illustrate this formula, assume that the order
size is 10 units. When the order is first received, there will be 10 units on hand. Just before the next order is
received, there will usually be zero units in inventory. Therefore, the average number of units on hand
throughout the period is 5, the average of 10 and 0, or E/2.

The costs for P and C, which are "fixed" with respect to the activity base (number of orders and number of
units ordered respectively), are not relevant to the model.

Exhibit 13-8 (Reading 9-1) shows a tabular version for calculating T as a function of the various order sizes.
This table is useful for practice and adapts well to the use of computer spreadsheets.

The formula for the economic order quantity is obtained by solving the minimization of total order cost T for
various order sizes O. It is of limited usefulness because of the restrictive assumptions, particularly the
assumption of no change in purchase cost as quantity changes and the assumption of no stock-out costs being
incurred.

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If quantity discounts are present, the total order costs should be modified to include the effects of changes in
purchase costs. The easiest way to do this is to add purchase costs per period to the formula for T:

T = carrying cost + order costs + purchase costs

A table is needed and is constructed by adding a new row for annual purchasing costs for each order size.
Some forms of the table insert the difference in prices (discounts foregone) for each order quantity to give
the annual loss for each order level. The smallest order sizes have the greatest cost, which means these orders
have to bear the extra cost of lost purchase discounts.

If periodic demand is not known, if usage is not regular throughout the period, if lead times vary, or if
multiple deliveries are necessary for each order, then careful tabular analysis of the problem is necessary
because the basic analysis tends to ignore these matters.

Management may find it is not worthwhile to avoid stock-out costs totally. It may be prepared to incur some
level of these costs because they are outweighed by savings from different order sizes. Stock-out costs are
the third category of costs listed on page 1 of Reading 9-1. Many of them represent opportunity costs
resulting from unavailable inventory, while some represent real out-of-pocket costs of making up the
shortage quickly. Items 3 and 5 are of this latter type, along with an obvious cost not included in the list —
the cost of placing the "extra" order in an emergency.

The economic order quantity formula in the textbook could be expanded to include the stock out costs as a
variable but the extension is complex and somewhat artificial.

To make decisions about the length of production runs, the simple case uses a tradeoff between the cost of
setting up runs for a period [P(Q/O)] and the cost of carrying the inventory for a period [C(O/2)], where P is
now the set-up cost for each run and O is the size of the production run.

Realistically, a more complex analysis is necessary, which recognizes that during the production cycle,
inventory is being both built up and used, and the average level of inventory thus depends on the rate of
production.

JIT systems may affect the EOQ calculation in two ways. The cost of placing an order may be less in a JIT
system because of more frequent orders. The cost of carrying inventory may be lower because the inventory
is always the supplier's most recent stock. Therefore, JIT proponents argue that there is less risk of
obsolescence.

The resulting calculation on page 5 of Reading 9-1 shows that the economic order quantity may be lower in a
JIT system. This conclusion is logical because JIT means that ordering is constant. You would expect a
company that orders frequently to have smaller order sizes compared to a company that orders sporadically.

LEVEL 2

The textbook material on safety stock and reorder points (Reading 9-2 (To view the content, go to the end
of this document.)) deals with the questions of when to order and how much inventory to keep on hand to
cover unexpected demands during the waiting time. Reorder point, for a single order case, is lead time in
days (or weeks) multiplied by average demand per day (or week) in units, plus safety stock.

Safety stock decisions are reasonably complex ones, trading off carrying costs of safety stock with stock-out
costs. The calculation on page 2 of the reading assumes a worst-case situation, that is, maximum demand
during the lead time so that again no tradeoff with stock-out costs is considered, since stock-outs will be
zero.

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Carefully review the examples in Reading 9-2, which introduce the effects of probabilities and expected
stock-out costs.

Activity 9-1 Economic order quantity (EOQ) demonstration

This activity reinforces your understanding of the Economic Order Quantity concept.

Audio lectures
Audio lectures are available for this module. System requirements and instructions on how to access the
online lectures are included.

Module 9 summary
This module consists of decision making issues.

Whatever the decision a manager has to make, management accounting plays a central role in providing only
information that is relevant to that decision. Topic 9.1 discusses the criteria of relevant costs.

Topic 9.2 deals with the decision of adding or dropping a product line, a decision that makes use of the tool
of segment reporting and examines capacity issue and possible interactions with other existing product lines.

Topic 9.3 focuses on make-or-buy decisions and introduces the use of the concept of opportunity cost of
possible capacity freed by a decision to buy from outside.

Extending the decision discussed in Topic 9.2 above, Topic 9.4 explores the decision to retain or to close a
store.

The special order or only-one-time order decision is the object of Topic 9.5, a decision that focuses on
incremental revenues and incremental costs.

Bottleneck is a common concern to many businesses, and Topic 9.6 examines a decision involving scarce
resources that is based on the contribution margin generated per unit of the constrained resource.

Topic 9.7 introduces the notion of joint products and raises the issue of selling them immediately at the split-
off point or processing them further.

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To conclude, Topic 9.8 is devoted to the decision of timing of and order size of inventory purchases.

Module 9 self-test
Question 1

Computer question

It is strongly suggested that you work through Computer illustration 9-1 before attempting this question.

Description

Hallas Company manufactures a fast-bonding glue in its Northwest plant. The company normally produces
and sells 50,000 litres of the glue each month. This glue, which is known as MJ-7, is used in the wood
industry in the manufacture of plywood. The selling price of MJ-7 is $57 per litre, variable costs are $42 per
litre, fixed overhead costs in the plant total $375,000 per month, and the fixed selling costs total $200,000
per month.

Strikes in the mills that purchase the bulk of the MJ-7 glue have caused Hallas Company's sales to
temporarily drop to only 37,500 litres per month. Hallas Company's management estimates that the strikes
will last for about three months, after which sales of MJ-7 should return to normal. However, due to the
current low level of sales, Hallas Company's management is thinking about closing down the Northwest
plant during the three months that the strikes are expected to last.

If Hallas Company does close down the Northwest plant, it is estimated that fixed overhead costs can be
reduced to only $225,000 per month and that fixed selling costs can be reduced by 18%. Start-up costs at the
end of the shutdown period would total $25,200. Since Hallas Company uses JIT production methods, no
inventories are on hand.

Note: This type of decision is similar to that of dropping a product line. Refer to the textbook material on this
topic (page 621) if needed.

Required

Use the procedure described below to prepare worksheet M9Q1. From this worksheet, answer the following
questions:

1.
a. What is the difference in the contribution margin for three months between keeping the plant
open and closing the plant?

b. What is the difference in the total fixed costs for three months between the two alternatives?

c. How should the $25,200 in start-up costs be incorporated into your numerical analysis?

d. Would you recommend that Hallas Company close the Northwest plant? Explain.

Hint: This is a type of break-even analysis, except that the fixed cost portion of your break-even
computation should include only those fixed costs that are relevant, that is, avoidable, over the three-

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month period.

2. At what level of sales (in litres) for the three-month period would Hallas Company be indifferent
between closing the plant or keeping it open?

3. The strike has caused a glut of MJ-7 type adhesives on the market, and Hallas will have to increase its
sales effort to be able to sell even 37,500 litres of MJ-7 per month. The company will have to cut its
selling price to $44 and increase its fixed selling expenses to $245,000 per month. Variable costs will
decrease to $36 per unit (by using lower-grade materials).

a. What is the difference in the contribution margin for three months between keeping the plant
open and closing the plant?

b. What is the difference in the total fixed costs for those months between the two alternatives?

c. Under these conditions, would you recommend that Hallas Company close the Northwest plant?
Explain.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Managerial Accounting,
Sixth Canadian Edition, Problem P13-17, page 653. Copyright © 2004, by McGraw-Hill Ryerson Limited.
Adapted with permission.

Procedure

1. Open the file MA1M9Q1.

2. The range in rows 17 to 32 has been allocated to build a comparative table to analyze the plant closure
decision. (Refer to Exhibit 13-3 and to Computer illustration 9-1 for examples.)

3. Beginning in row 6, enter the selling price in column D. Complete the data table by entering the
necessary information given in the Description in column D to construct a comparative table for the
plant closure analysis.

4. Beginning in row 19, build the comparative table. Your table should contain formulas that reference
the values in the data table. (You should use Exhibit 13-3 as a guide in building the comparative table.)

5. Format your completed worksheet (showing $ where appropriate). If you require additional
information on formatting your worksheet, refer to the computer tutorial CT2.

6. Leave a blank row at the end of your comparative table and enter the following label in column A:
Break-even point.

7. Enter in column B the formula to calculate the break-even point to answer requirement 2 of the
question.

8. Save your completed worksheet.

9. Display the formulas in your completed worksheet.

10. Using the worksheet you have completed, enter the appropriate changes to the data table to answer
requirement 3.

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Solution

Question 2

Multiple choice

a. Which of the following is a cost incurred as a consequence of a past irrevocable decision and therefore
cannot be avoided?

1. Out-of-pocket cost
2. Relevant cost
3. Sunk cost
4. Opportunity cost

b. AJ Inc. is planning to purchase a new computer system to replace the existing one. Which of the
following is relevant to AJ Inc.'s decision (ignore income tax considerations)?

Disposal amount Carrying value

of existing system of existing system

1. Yes Yes
2. No No
3. Yes No
4. No Yes

c. Which of the following is a cost that requires a future outlay of cash and is relevant for current and
future decisions?

1. Opportunity cost
2. Relevant cost
3. Sunk cost
4. Out-of-pocket cost

d. The potential benefit of one alternative that is lost by choosing another alternative is known as which
of the following?

1. Relevant cost
2. Sunk cost
3. Opportunity cost
4. Out-of-pocket cost

Solution

Question 3

Textbook, Question 13-3, page 644.

Solution

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Question 4

Textbook, Exercise 13-9, page 649.

Solution

Question 5

Textbook, Problem 13-21, page 656.

Solution

Question 6

Textbook, Problem 13-19, pages 654-655.

Solution

Question 7

Textbook, Problem 13-25, page 659.

Solution

Question 8

Textbook, Problem 13-23, pages 657-658.

Solution

Self-test - Content Links

Solution 1

Computer solution

Requirement 1

a. The difference in the contribution margin between the two options for three months is $1,687,500.

b. The difference in total fixed costs between the two alternatives for three months is $558,000.

c. The $25,200 in start-up costs should be added as an additional cost under the plant closing option.

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d. I would recommend that Hallas Company keep the Northwest plant open because it will lose less by
keeping it open as opposed to shutting it down for three months.

Requirement 2

The break-even point is 35,520 litres, calculated as follows:

Requirement 3

a. The difference in the contribution margin for three months between keeping the plant open and closing
the plant is $900,000.

b. The difference in total fixed costs between the two alternatives for three months is $582,300.

c. Under these conditions and based strictly on quantitative analysis, Hallas would be better off by
keeping the plant open because the net loss will be lower under this option.

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Formula printout of requirement 1

Solution printout of requirement 3

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Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 2

Multiple choice

a. 3)

A sunk cost is defined; it is irrelevant to any decision affecting future decisions.

b. 3)

Only future cash flows that differ between alternatives are relevant. The carrying amount of the old machine
is irrelevant because it does not involve future cash flows.

c. 4)

An out-of-pocket cost is a cost that requires a future outlay of cash and is relevant for current and future
decisions.

d. 3)

An opportunity cost is the potential benefit lost by taking a specific course of action when two or more
alternative choices are available.

Solution 3

Question 13-3

No. Variable costs are relevant costs only if they differ between the alternatives under consideration.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 4

Problem 13-9

No, the overnight cases should not be discontinued. The computations are:

Contribution margin lost if the cases are discontinued $(260,000)

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Less fixed costs that can be avoided if the cases are discontinued:

Salary of the product line manager $ 21,000

Advertising 110,00
Insurance on inventories 9,000 140,000
Net disadvantage of dropping the cases $(120,000)

The same solution can be obtained by preparing comparative income statements:

Keep
overnight Drop overnight Difference: Net operating
cases cases income increase or (decrease)
Sales $450,000 $ 0 $(450,000)
Less variable expenses:
Variable manufacturing
expenses 130,000 0 130,000
Sales commissions 48,000 0 48,000
Shipping 12,000 0 12,000
Total variable expenses 190,000 0 190,000
Contribution margin 260,000 0 (260,000)
Less fixed expenses:
Salary of line manager 21,000 0 21,000
General factory overhead 104,000 104,000 0
Depreciation of equipment 36,000 36,000 0
Advertising — traceable 110,000 0 110,000
Insurance on inventories 9,000 0 9,000
Purchasing department
expenses 50,000 50,000 0
Total fixed expenses 330,000 190,000 50,000
Net operating loss $(70,000) $(190,000) $(120,000)

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 5

Problem 13-21

1. The $2.00 per unit general overhead cost is not relevant to the decision, because the total general
company overhead cost will be the same regardless of whether the company decides to make or buy
the subassemblies. Also, the depreciation on the old equipment is not a relevant cost since it represents

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a sunk cost, and the old equipment is worn out and must be replaced. The cost of supervision is
relevant because this cost can be avoided by buying the subassemblies.

* $60,000 per year ÷ 40,000 units per year = $1.50 per unit

2. a. Notice that unit costs for both supervision and equipment rental will change if the company needs
50,000 subassemblies each year. These fixed costs will be spread over a larger number of units,
thereby decreasing the cost per unit.

The company would be indifferent between the two alternatives if 50,000 subassemblies were needed each
year.

b. Again, notice that the unit costs for both supervision and equipment rental decrease with the greater
volume of units.

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The company should purchase the new equipment and make the subassemblies if 60,000 units per year are
needed.

3. Other factors that the company should consider include:

a. Will volume in future years be increasing, or will it remain constant at 40,000 units per year? (If
volume increases, then buying the new equipment becomes more desirable, as shown in the
computations above.)

b. Can quality control be maintained if the subassemblies are purchased from the outside supplier?

c. Does the company have some other profitable use for the space now being used to produce the
subassemblies? Does production of the subassemblies require use of a constrained resource?

d. Will the outside supplier be dependable in meeting shipping schedules?

e. Can the company begin making the subassemblies again if the supplier proves to be undependable, or
are there alternative suppliers?

f. If the outside supplier's offer is accepted and the need for subassemblies increases in future years, will
the supplier have the capacity to provide more than 40,000 subassemblies per year?

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 6

Problem 13-19

Requirement 1

1.

Page 18 of 22
 Management Accounting Fundamentals [MA1]

Incremental revenue:
Fixed fee (10,000 pairs × €4 per pair) € 40,000
Reimbursement for costs of production: (Variable production cost of €16 plus fixed
overhead cost of €5 equals €21 per pair; 10,000 pairs × €21 per pair) 210,000
Total incremental revenue 250,000
Incremental costs:
Variable production costs (10,000 pairs × €16 per pair) 160,000
Increase in net operating income € 90,000

Requirement 2

2.
Sales revenue through regular channels
(10,000 pairs × €32 per pair) €320,000
Sales revenue from the army (above) 250,000
Decrease in revenue received 70,000
Less variable selling expenses avoided if the army’s offer is
accepted (10,000 pairs × €2 per pair) 20,000
Net decrease in net operating income with the army’s offer € 50,000

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 7

Problem 13-25

Requirement 1

1. A product should be processed further so long as the incremental revenue from the further processing
exceeds the incremental costs. The incremental revenue from further processing of the honey is:

Selling price of a container of honey drop candies $4.40

Selling price of 345 grams of honey ($3.30 × .345) 1.14
Incremental revenue per container $3.26

The incremental variable costs are:

Decorative container $0.40

Other ingredients 0.25
Direct labour 0.20
Variable manufacturing overhead 0.10
Commissions (5% × $4.40) 0.22

Page 19 of 22
 Management Accounting Fundamentals [MA1]

Incremental variable cost per container $1.17

Therefore, the incremental contribution margin is $2.09 per container ($3.26 – $1.17). The cost of
purchasing the honeycombs is not relevant because those costs are incurred regardless of whether the
honey is sold outright or processed further into candies.

Requirement 2

2. The only avoidable fixed costs of the honey drop candies are the master candy maker’s salary and the
fixed portion of the salesperson’s compensation. Therefore, the number of containers of the candy that
must be sold each month to justify continued processing of the honey into candies is determined as
follows:

Master candy maker’s salary $3,700

Salesperson’s fixed compensation 2,000
Avoidable fixed costs $5,700

Avoidable fixed costs $5,700

= = 2,727 containers
Incremental CM per container $2.09 per container

If the company can sell more than 2,727 containers of the candies each month, then profits will be higher
than if the honey were simply sold outright. If the company cannot sell at least 2,727 containers of the
candies each month, then profits will be higher if the company discontinues making honey drop candies.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 8

Problem 13-23

Requirement 1

1. Only the avoidable costs are relevant in a decision to drop the Kensington product line. These costs
are:

Direct materials £ 32,000

Direct labour 200,000
Fringe benefits (30% of labour) 60,000
Variable manufacturing overhead 30,000
Royalties (5% of sales) 24,000
Product-line managers’ salaries 8,000
Sales commissions (10% of sales) 48,000
Fringe benefits (30% of salaries and commissions) 16,800
Shipping 10,000

Page 20 of 22
 Management Accounting Fundamentals [MA1]

Advertising 5,000
Total avoidable cost £443,800

The following costs are not relevant in this decision:

Cost Reason not relevant

Building rent and maintenance
Depreciation
General administrative expenses
All products use the same facilities; no
space would be freed up if a product were
dropped.
All products use the same equipment so no
equipment can be sold. Furthermore, the
equipment does not wear out through use.
Dropping the Kensington product line
would have no effect on total general
administrative expenses.

Having determined the costs that can be avoided if the Kensington product line is dropped, we can
now make the following computation:

Sales revenue lost if the Kensington line is dropped £480,000

Less costs that can be avoided (see above) 443,800
Decrease in overall company net operating income if the Kensington
line is dropped £ 36,200

Thus, the Kensington line should not be dropped unless the company can find more profitable uses for the
resources consumed by the Kensington line.

Requirement 2

2. To determine the minimum acceptable sales level, we must first classify the avoidable costs into
variable and fixed costs as follows:

Variable Fi xed
Direct materials £ 32,000
Direct labour 200,000
Fringe benefits (30% of labour) 60,000
Variable manufacturing overhead 30,000
Royalties (5% of sales) 24,000
Product-line managers’ salaries £
Sales commissions (10% of sales) 48,000
Fringe benefits
(30% of salaries and commissions) 14,400
Shipping 10,000
Advertising 15,000

Total cost £ 418,400 £ 25,400

Page 21 of 22
 Management Accounting Fundamentals [MA1]

The Kensington product line should be retained as long as its contribution margin covers its avoidable fixed
costs. Break-even analysis can be used to find the sales volume where the contribution margin just equals the
avoidable fixed costs.

The contribution margin ratio is computed as follows:

And the break-even sales volume can be found using the break-even formula:

Therefore, as long as the sales revenue from the Kensington product line exceeds £198,000, it is
covering its own avoidable fixed costs and is contributing toward covering the common fixed
costs and toward the profits of the entire company.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions
Manual to accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by
McGraw-Hill Ryerson Limited. Reproduced with permission.

Page 22 of 22
READING 9-1
INVENTORY DECISIONS
Inventory planning and control decisions are an important aspect of the
management of many organizations. Inventory levels are not left to chance but
rather are carefully planned. Major questions left unanswered are: How does the
manager know what inventory level is right for the firm? and Won’t the level that
is right vary from organization to organization? The purpose of this section is to
examine the inventory control methods available to the manager to answer these
questions and the relevant costs for these decisions.

Costs Associated with Inventory

Three groups of costs are associated with inventory. The first group, known as
inventory ordering costs, consists of costs associated with the acquisition of
inventory. Examples include:
1. Clerical costs.
2. Transportation costs.

The second group, known as inventory carrying costs, consists of costs that arise
from having inventory on hand. Examples include:
1. Storage space costs.
2. Handling costs.
3. Property taxes.
4. Insurance.
5. Obsolescence losses.
6. Interest on capital invested in inventory.

The third group, known as costs of not carrying sufficient inventory, consists of
costs that result from not having enough inventory on hand to meet customers’
needs. Costs in this group are more difficult to identify than costs in the other two
groups, but nevertheless they can include items that are very significant to a firm.
Examples of costs in this group are:
1. Customer ill will.
2. Quantity discounts foregone.
3. Erratic production (expediting of goods, extra setup, etc.)
4. Inefficiency of production runs.
5. Added transportation charges.
6. Lost sales.

In a broad conceptual sense, the right level of inventory to carry is the level that
minimizes the total of these three groups of costs. Such a minimization is difficult
to achieve, however, because certain of the costs involved are in direct conflict
with one another. Notice, for example, that as inventory levels increase, the costs
of carrying inventory also increase, but the costs of not carrying sufficient
inventory decrease. In working toward total cost minimization, therefore, the
manager must balance off the three groups of costs against one another. The

Management Accounting 1 Reading 9-1 ! 1

 problem really has two dimensions — how much to order (or how much to
produce in a production run) and how often to do it.

Computing the Economic Order Quantity

The how-much-to-order question is commonly referred to as the economic order
quantity. It is the order size that results in a minimization of the first two groups
of costs just described. We consider two approaches to computing the economic
order quantity — the tabular approach and the formula approach.

The Tabular Approach

Given a certain annual consumption of an item, a firm might place a few orders
each year of a large quantity each, or it might place many orders of a small
quantity each. Placing only a few orders will result in low inventory ordering
costs but in high inventory carrying costs, as the average inventory level would be
very large. On the other hand, placing many orders would result in high inventory
ordering costs but in low inventory carrying costs; in this case the average
inventory level would be quite small. As stated earlier, the economic order
quantity seeks the order size that balances off these two groups of costs. To show
how it is computed, assume that a manufacturer used 3,000 subassemblies
(manufactured parts inserted in other manufactured items) in the manufacturing
process each year. The subassemblies are purchased from a supplier at a cost of
$20 each. Other cost data are given below:
Inventory carrying costs, per unit, per year ....... $0.80
Cost of replacing a purchase order..................... 10.00

EXHIBIT 13-8
Tabulation of Costs Associated with Various Order Sizes
Order Size in Units
Symbol* 25 50 100 200 250 300 400 1,000 3,000
E/2 Average inventory in units 12.5 25 50 100 125 150 200 500 1,500
Q/E Number of purchase orders 120 60 30 15 12 10 7.5 3 1
C(E/2) Annual carrying cost at $0.80
per unit $10 $20 $40 $80 $100 $120 $160 $400 $1,200
P(Q/E) Annual purchase order cost
at $10 per order 1,200 600 300 150 120 100 75 30 10
T Total annual cost $1,210 $620 $340 $230 $220 $220 $235 $430 $1,210

*Symbols:
E = order size in units (see headings above).
Q = Annual quantity used in units (3,000 in this example).
C = Annual cost of carrying one unit in stock.
P = Cost of placing one order.
T = Total annual cost = P(Q/E) + C(E/2)

Exhibit 13-8 contains a tabulation of the total costs associated with various order
sizes for the subassemblies. Notice the total annual cost is lowest (and is equal) at
the 250- and 300-unit order sizes. The economic order quantity lies somewhere

2 ! Reading 9-1 Management Accounting 1

 between these two points. We could locate it precisely by adding more columns to
the tabulation, and we would in time zero in on 274 units as being the exact
economic order quantity.

The cost relationships from this tabulation are shown graphically in Exhibit 13-9.
Notice from the graph that total annual cost is minimized at that point when
annual carrying costs and annual purchase order costs are equal. The same point
identifies the economic order quantity, because the purpose of the computation is
to find the point of exact trade-off between these two classes of costs.

EXHIBIT 13-9
Graphical Solution to Economic Order Size

Observe from the graph that total cost shows a tendency to flatten out between
200 and 400 units. Most firms look for this minimum cost range and choose an
order size that falls within it, rather than choosing the exact economic order
quantity. The primary reason is that suppliers will often ship goods only in round-
lot sizes.

The table in Exhibit 13-8 is based on the formula:

T = P(Q/E) + C(E/2)

Management Accounting 1 Reading 9-1 ! 3

 where P is a constant cost per order, and C is a unit cost of carrying a unit of
inventory for the period of time under consideration. If quantity discounts can be
obtained for orders of a certain size, another term representing the purchase costs
of the particular lot size should be added to the formula or another line to the
table. Other complications arise where annual or period demand is not known,
lead times vary, or multiple deliveries are necessary for each order.

The Formula Approach. The economic order quantity can also be found by
means of a formula. The formula is derived by solving the minimization of T =
P(Q/E) + C(E/2) for E using calculus. The result is
2QP
E=
C
where
E = order size in units
Q = annual quantity used in units
P = cost of placing one order
C = annual cost of carrying one unit in stock

Substituting with the data used in our preceding example, we have:

Q = $3,000 subassemblies used per year
P = $10 cost to place one order
C = $0.80 cost to carry one subassembly in stock for one year

2(3,000)($10) $60,000
E= = = 75,000
$0.80 $0.80
E = 274 (the economic order quantity)

Although data can be obtained very quickly using the formula approach, it has the
drawback of not providing as great a range of information as the method
discussed previously, and it cannot be used where changes in purchase prices
occur with changes in lot sizes.

Focus on Current Practice Research suggests that companies do, indeed, understate the cost of carrying
a unit in stock. The reason for the understatement is that companies tend to
consider only the variable costs of carrying goods and to ignore other costs
such as depreciation (or rent) on facilities, material handling, accounting, and
administration.14 Yet these other costs can be more significant in the EOQ
computation than the variable costs. Indeed, one factor that has propelled the
Japanese toward JIT has been the extremely high cost of storage space in
Japan. Real estate is so costly that companies can’t afford to use valuable
space to store inventory. In effect, the high inventory carrying costs in Japan
have pushed the EOQ downward to the point where JIT is the only feasible
alternative.

4 ! Reading 9-1 Management Accounting 1

JIT and the Economic Order Quantity
The EOQ will decrease under either of these circumstances:
1. The cost of placing an order decreases.
2. The cost of carrying inventory in stock increases.

Managers who advocate JIT purchasing argue that the cost of carrying inventory
in stock is much greater than generally realized because of the waste and
inefficiency that inventories create. These managers argue that this fact, combined
with the fact that JIT purchasing dramatically reduces the cost of placing an order,
is solid evidence that companies should purchase more frequently in smaller
amounts. Assume, for example, that a company has used the following data to
compute its EOQ:
Q = 1,000 units needed each year
P = $60 cost to place one order
C = $3 cost to carry one unit in stock for one year

Given these data, the EOQ would be:

2QP 2(1,000)($60)
E= = = 40,000
C $3
E = 200 units

Now assume that as a result of JIT purchasing the company is able to decrease the
cost of placing an order to only $10. Also assume that because of the waste and
inefficiency caused by inventories, the true cost of carrying a unit in stock is $8
per year. The revised EOQ would be:
2QP 2(1,000)($10)
E= = = 2,500
C $8
E = 50 units

Under JIT purchasing, the company would not necessarily order in 50-unit lots
since purchases would be geared to current demand. This example shows quite
dramatically, however, the economics behind the JIT concept as far as the
purchasing of goods is concerned.

Production Lot Size

The economic order quantity concept can also be applied to the problem of
determining the economic production lot size. Deciding when to start and when
to stop production runs is a problem that has plagued manufacturers for years. The
problem can be solved quite easily by inserting the setup cost for a new
production lot into the economic order quantity formula in place of the purchase
order cost. The setup cost includes the labour and other costs involved in making
facilities ready for a run of a different production item.

To illustrate, assume that Chittenden Company has determined that the following
costs are associated with one of its product lines:

Management Accounting 1 Reading 9-1 ! 5

 Q = 15,000 units produced each year
P = $150 setup costs to change production from one product to another
C = $2 to carry one unit in stock for one year

What is the optimal production lot size for this product line? It can be determined
by using the same formula used to compute the economic order quantity:
2(15,000)($150) $4,500,000
O= = = 2,250,000
$2 $2
O = 1,500 (economic production lot size in units)

The Chittenden Company will minimize its overall costs by producing in lots of
1,500 units each. Tabular analysis of the form presented in Exhibit 14-8 can be
used to provide a more flexible model for the planning of production lot sizes.

JIT systems are being touted as a total manufacturing system for repetitive
manufacturing environments such as those used to produce food and beverages,
electrical products, textiles, and automobiles. Small lot production and flexible
manufacturing are key elements to the system.15 Distances in Canada may pose a
problem for some industries but not necessarily for all. The seasonal nature of
some businesses may preclude the use of JIT because additional production
capacity is simply too costly to permit production only when the need is evident
in the form of customer orders. However, the potential improvements in
productivity and quality together with the reduction in needed investment in
inventory make JIT production an option to be seriously investigated for
manufacturers and processors.

JIT production philosophy, when it was originated, examined carefully the

assumptions in economic production lot size analysis. The typical analysis as
presented earlier assumes setup time is a known fixed cost, for example, $150 per
setup in the preceding example. JIT approached this production lot size problem
by attempting to reduce setup costs to zero. If setup costs in the Chittenden
Company example were $0.0, the economic production lot size in units would be
one, a JIT production approach. The less the setup cost, the smaller the production
lots. Production approaches have been redesigned in some operations so that
many different products can be manufactured at little or no setup costs. For
example, a world-class automobile manufacturer has been noted as being able to
change from one model to another in 2.5 minutes, a complete retooling
operation.16

ENDNOTES
14
Daniel J. Jones, “JIT and the EOQ Model,” Management Accounting (February 1991), p. 57.
15
Alan T. G. Saipe, “Just-in-Time Holds Promise for Manufacturing Productivity,” Cost and
Management, May – June 1984, pp.41-43.
16
Robert D’Amore, “Just-Time-Systems,” Cost Accounting, Robotics, and the New
Manufacturing Environment, ed. Robert Capettini and Donald K. Clancy (Sarasota, Fla.:
American Accounting Association, 1987), p.82.
Adapted from R.H. Garrison, E.W. Noreen, G.R. Chesley, R.F. Carroll. Managerial Accounting:
Concepts for Panning, Control, Decision Making (4th Canadian edition, 1993). McGraw-Hill
Ryerson: Toronto. Pages 713-718.

6 ! Reading 9-1 Management Accounting 1

READING 9-2
Reorder Point and Safety Stock
We stated earlier that the inventory problem has two dimensions — how much to
order and how often to do it. How often to do it involves what are commonly
termed the reorder point and the safety stock, and seeks to find the optimal
tradeoff between the second two groups of inventory costs outlined earlier (the
costs of carrying inventory and the costs of not carrying sufficient inventory).
First, we will discuss the reorder point and the factors involved in its computation.
Then, we discuss the circumstances under which a safety stock must be
maintained.

The reorder point tells the manager when to place an order or when to initiate
production to replenish depleted stocks. It is dependent on three factors — the
economic order quantity (or economic production lot size), the lead time, and the
rate of usage during the lead time. The lead time can be defined as the interval
between the time that an order is placed and the time that the order is finally
received from the supplier or from the production line.

Constant Usage during the Lead Time. If the rate of usage during the lead
time is known with certainty, the reorder point can be determined by the
following formula:
Reorder point = Lead time × Average daily or weekly usage

To illustrate the formula’s use, assume that a company’s economic order quantity
is 500 units, that the lead time is 3 weeks, and that the average weekly usage is 50
units.
Reorder point = 3 weeks × 50 units per week = 150 units

The reorder point would be 150 units. That is, the company automatically places a
new order for 500 units when inventory stock drops to a level of 150 units, or
three weeks’ supply, left on hand.

Variable Usage during the Lead Time. The previous example assumed that
the 50 units per week usage rate was constant and was known with certainty.
Although some firms enjoy the luxury of certainty, the more common situation is
to find considerable variation in the rate of usage of inventory items from period
to period. If usage varies from period to period, the firm that reorders in the way
computed earlier may soon find itself out of stock. A sudden spurt in demand, a
delay in delivery, or a snag in processing an order may cause inventory levels to
be depleted before a new shipment arrives.

Companies that experience problems in demand, delivery, or processing of orders

have found that they need some type of buffer to guard against stock-outs. Such a
buffer is usually called a safety stock. A safety stock serves as insurance against
greater-than-usual demand and against problems in the ordering and delivery of
goods. Its size is determined by deducting average usage from the maximum

Management Account 1 Reading 9-2  1

 usage that can reasonably be expected during a period. For example, if the firm in
the preceding example was faced with a situation of variable demand for its
product, it would compute a safety stock as follows:
Maximum expected usage per week ........ 73.3 units
Average usage per week .......................... 50
Excess ................................................ 23.3 units
Lead time ................................................. × 3 weeks
Safety stock.............................................. 70 units

The reorder point is then determined by adding the safety stock to the average
usage during the lead time, in formula form, the reorder point will be:
Reorder point = (Lead rime × Average daily or weekly usage) + Safety
stock

Computation of the reorder point by this approach is shown both numerically and
graphically in Exhibit 13-10. As shown in the exhibit, the company places a new
order for 500 units when inventory stocks drop to a level of 220 units left on
hand.

If management does not wish to assume the worst-case situation by using the
maximum expected usage per week, then a slightly more complex calculation of
the safety stock is necessary as shown in Exhibit 13-11 and based on the data that
follow. Assume management makes the following estimates for a yearly period:
Carrying cost per year, $1 per unit
Stock-out cost per unit, $0.60
Average usage per week, 50
Orders placed per year, 12

Demand Probabilities
80..................... 0.05
120..................... 0.06
140..................... 0.20
150..................... 0.38
160..................... 0.20
180..................... 0.06
220..................... 0.05
1.00

2  Reading 9-2 Management Accounting 1

EXHIBIT 13-10
Determining the Reorder Point — Variable Usage

Economic order quantity........ 500 units

Lead time ............................... 3 weeks
Average weekly usage ........... 50 units
Maximum weekly usage ........ 73.3 units
Safety stock............................ 70 units

Reorder point = (3 weeks × 50 units per week) + 70 units = 220 units.

These estimates reflect the uncertainty experienced by management when they

face the various demand possibilities. The table of demand levels and
corresponding probabilities presents how management has described the
uncertainty they face. This description will, as we shall see, be incorporated in the
safety stock calculation.

The calculation of the optimal safety stock begins by computing the various
inventory quantities that the demand probabilities indicate could be satisfied by
the safety stock. These quantities are the demand quantities in excess of the
expected demand during the lead time period. Calculation a in Exhibit 13-11
illustrates the amounts. Each unit of safety stock inventory will be on hand for the
year (the typical time period used), so the carrying costs per unit of inventory per
year is used to determine the first cost element, the total carrying cost and the
safety stock per year.

Management Account 1 Reading 9-2  3

EXHIBIT 13-11
Safety Stock Level
(a) (b) (c) (d) (e)
Safety Stock Total Stock-Out Stock-Out Number of Probability Expected Total Cost
Level in Carrying in Units Cost per Times of Stock- Stock-Out per Year
Units Cost per Order Time Orders Out Cost per
Year Placed Year
-0- $-0- 10 $6.00 12 0.20 $14.40
30 18.00 12 0.06 12.96
70 42.00 12 0.05 25.20 $52.56

10 10 20 12.00 12 0.06 8.64

60 36.00 12 0.05 21.60 40.24
30 30 40 24.00 12 0.05 14.40 44.40
70 70 0 0.00 12 0.00 0.00 70.00

a. Safety stock level is possible demand minus expected demand (e.g., 180 –
150 = 30). Carrying cost of safety stock is units times cost per unit to carry
(e.g., 30 × $1 = 30).
b. Stock-out in units is possible demand minus expected demand minus
safety stocks (e.g., 220 – 150 – 10 = 60; 180 – 150 – 10 = 20).
c. Stock-out cost per order time is stock-out in unit times stock-out cost per
unit (e.g., 30 × $0.60 = $18.00; 40 × 0.60 = $24.00).
d. Expected stock-out cost per year is stock-out cost per time the order is
placed, times the number of orders placed per year, times the probability
of a stock-out each time (e.g., $6 × 12 × 0.20 = $14.40; $12 × 12 × 0.06 =
$8.64). The probability of a stock-out is obtained from the data for various
demand levels in excess of the expected amount of 150 plus the safety
stock.
e. Total cost per year is the carrying cost of the safety stock plus the
expected stock-out cost per year for the appropriate demand levels (e.g.,
$0.0 + $14.40 + $12.96 + $25.20 = $52.56; $30 + $14.40 = $44.40).

The second set of calculations computes the stock-out costs caused because
demand exceeds the safety stock quantity. Column b in Exhibit 13-11 reflects the
excess demand possibilities above the safety stock and the average demand during
the lead time, in other words, the stock-out quantity. The stock-out in units is
multiplied by the stock-out cost per unit of 60 cents to give the stock-out cost for
each time an order is placed. Knowledge of the average inventory usage per year
and the order size is used to determine the number of times orders are placed in a
year. To determine the stock-out total costs, the stock-out cost per order is
multiplied by the number of orders per year by the probability of each possible
demand level to yield column d. The sum of the total carrying cost for the safety
stock and the expected stock-out costs give the cost for each safety stock level.
The lowest expected total costs provide the optimal level of safety stock. Notice
that Exhibit 13-11 suggests 10 is the optimal level, with a total cost of carrying
the safety stock of $40.24. The conservative maximum safety stock level of 70
suggested earlier had an annual cost of $70 in this illustration.

4  Reading 9-2 Management Accounting 1

Perishable Products
Inventory problems for perishable products or services such as hotel rooms pose
an interesting and somewhat different inventory problem. Basically, if too much
or many are ordered, the cost of the inventory is similar to a carrying cost, while
ordering too few has the cost of contribution foregone from the lost sale. A firm
cannot sell what it does not have, while it loses what it purchased but did not sell.

Assume the following:

Purchase cost $3 per unit.
Selling price $5 per unit.

Remember:
You cannot sell what you do not have.
What you buy but cannot sell is lost.

EXHIBIT 13-12
Calculation of Optimal Inventory
Profitability of Order/Demand Combinations
and Probability/Demand

0.10 0.15 0.05 0.40 0.30

Inventory 1 2 3 4 5 Expected Profit

1........................ $2 $2 $2 $2 $2 $2.00
2........................ -1 4 4 4 4 3.50
3........................ -4 1 6 6 6 4.25
4........................ -7 -2 3 8 8 4.75
5........................ -10 -5 -0- 5 10 3.25*

Note: Four units is the optimum level of inventory because it has the greatest profit, $4.75.
*Profit × probability; for example, [0.10(-10) + 0.15(-5) + 0.05(0) + 0.40(5) + 0.30(10)] = $325.

Carefully review the calculations in Exhibit 13-12 to see how the information can
be combined to select the optimum inventory level.

For perishable products, each unsold unit of inventory generally is lost; at best, it
may receive a rebate from the inventory supplier. Comparison of the total revenue
based on demand quantities time selling prices, with the purchase cost of the
inventory adjusted for any rebates or returns, determines the cell profit or loss for
each combination of demand and inventory shown in Exhibit 13-12. Because the
demand levels are uncertain, each possible net income before income taxes for the
particular inventory level is multiplied by the probability of the demand level to
yield the expected profits. The maximum expected profit is considered to be the
indicator of the optimum inventory level.

Adapted from R.H. Garrison, E.W. Noreen, G.R. Chesley, R.F. Carroll. Managerial Accounting:
Concepts for Panning, Control, Decision Making (4th Canadian edition, 1993). McGraw-Hill
Ryerson: Toronto. Pages 718-722.

Management Account 1 Reading 9-2  5