Module 4: Inventory management

Overview
Module 4 examines the relationship between inventory management and relevant costs of inventory. You learn more about
the effects of carrying costs, economic order quantity (EOQ), and just-in-time (J IT) inventory and production systems. You
compare backflush costing with traditional costing systems and conclude your work on Module 4 with a case study on
implementing a J IT costing system.
Test your knowledge
Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study
required.
Assignment reminder
Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). If you have not already done so, review the
assignment now so that you are familiar with the requirements as you work through Modules 4 and 5.
Topic outline and learning objectives
4.1 Inventory management and EOQ Make recommendations based on the calculation of total
annual relevant costs, economic order quantity, re-order
points, and safety stock levels. (Level 1)

4.2 Estimating inventory-related costs Describe the impact of errors in estimating inventory-
related costs, and explain the importance of goal
congruence. (Level 2)

4.3 Relevance and the JIT strategy of supply-
chain management
Describe the role of JIT strategy and supply-chain analysis
and management. (Level 2)

4.4 MRP and ERP inventory management
systems
Describe materials requirement planning and enterprise
resource planning production systems. (Level 2)

4.5 Backflush costing Prepare journal entries for inventory transactions using
backflush costing in a JIT environment. (Level 1)

4.6 Case: Supply-chain management Analyze a supply-change management scenario, and make
recommendations. (Level 1)

Module summary
Print this module
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Updated August 16, 2010, MA2-TU02,
September 7, 2010, MA2-TU04
4.1 Inventory management and EOQ
Learning objective
Make recommendations based on the calculation of total annual relevant costs, economic order quantity, re-order
points, and safety stock levels. (Level 1)
Required reading
Chapter 20, pages 964-973
LEVEL 1
Inventory management requires planning, coordinating, and controlling activities related to the flow of inventory to the
company, through the organization (value chain), and to the final customer. For operations such as supermarkets, retail
stores, and manufacturing companies, inventory represents the largest single cost. Inventory can also be a source of
competitive advantage through the product itself and also through the use of efficient distribution channels.
In addition to costs of quality (Module 3), the following are major costs associated with inventory management:
Purchasing costs of acquiring goods from suppliers, including incoming freight or transportation costs and
discounts

Ordering costs of preparing, issuing, and paying purchase orders, and receiving, processing, and inspecting
orders

Carrying costs of holding an inventory of goods for sale, including opportunity costs of investment tied up in
inventory and costs associated with storage (space rental, insurance, obsolescence, spoilage); carrying the right
amount of inventory can reduce carrying costs, and carrying too little inventory creates the possibility of stockouts

Stockout costs incurred when an organization runs out of an item for which there is customer demand; includes
costs of expediting orders from suppliers, and opportunity costs of lost contribution margin and customer
dissatisfaction

Shrinkage costs arising from theft, embezzlement, misclassification, and clerical errors; control of shrinkage is a
primary concern for managers, especially in retail operations
Advances in information technology such as radio-frequency identification, bar coding, and scanning technology increase the
reliability and timeliness of inventory information, and help reduce inventory costs.
Economic order quantity (EOQ)
A key focus of inventory control is the question of how much inventory to carry. When making this decision, managers
consider the costs of ordering and carrying inventory. In your introductory management accounting course you learned that
the economic order quantity (EOQ) is a decision model that takes these costs into account when determining the optimal
amount of inventory to keep on hand to satisfy customer demand and to reduce costs.
Work through the following example to calculate economic order quantity and to determine when to re-order running shoes
at a sporting equipment retail store.
Example 4.1-1: Inventory management at Sanpan Inc.
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Sanpan Inc. sells sporting equipment. One brand of high-tech running shoe Sanpan orders regularly costs $60. The
shipments are made FOB destination (meaning the seller pays all shipping costs). Annual demand is 8,000 pairs of the shoes.
The company has a required rate of return of 12% on investments. Purchase order lead time is 7 days. Relevant insurance
costs, material-handling, and so on, is $1200 per year. Relevant ordering costs are $40 per order.

Calculate EOQ



Relevant carrying costs = $1200.00 8000 + (12% $60.00) = $0.15 + $7.20 = $7.35
The total annual relevant costs (TRC) can be calculated as:
Total relevant costs = Ordering costs + Carrying costs
TRC = (D/Q) x P + (Q/2) x C or TRC = (DP/Q) + (QC/2)
*Q can be any quantity ordered, not necessarily the EOQ.
Here is the TRC for the EOQ:
TRC = (D/Q) P + (Q/2) C
= (8,000 295) x $40.00 + (295 2) x $7.35
= $1,085.00 + $1,085.00
= $2,170.00
The number of deliveries each time period would be as follows:

D/EOQ = 8,000 295 = 27.11, or 28 deliveries.

Re-order point
Re-order point = Number of units sold (per unit of time) x Purchase order lead time.
Using the Sanpan inventory data, you can calculate the reorder point as follows:
Number of units sold per week: 8,000 52 = 154 pairs.
Re-order point = 154 pair of running shoes per week x 1 week = 154.
When the inventory falls to 154 pairs of running shoes (out of the 295 pairs per order), the company should reorder.
Safety stock
Because of uncertainties of demand, companies hold a safety stock, or cushion of inventory, to use as a buffer against
problems in delivery or to reduce the chance of stockout situations. To calculate safety stock, managers consider relevant
stockout costs including costs of rush shipments and inventory carrying costs. The optimal safety stock level minimizes
stockout costs and carrying costs.
When companies hold a safety stock, the reorder point calculation is adjusted as follows:
Re-order point = Number of units sold (per unit of time) x Purchase order lead time + Safety stock.
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Activity 4.1-1: Economic order quantity
To test your understanding of the application of EOQ calculations, work through Activity 4.1-1, checking your answers for
each problem as you go.
Just-in-time (JIT) purchasing
J IT purchasing aims to reduce carrying costs, scrap, obsolescence, and non-value added time, with resulting increased
customer satisfaction. With J IT purchasing, delivery of goods or materials immediately precedes their demand or use. A J IT
system affects both the buyer and seller in the supply chain because it requires more frequent and smaller order lots from
suppliers. This type of system works well when availability and prices of resources are constant and production cycles are
well controlled.
J IT systems result in reduced carrying costs of inventory such as warehousing, insurance, and labour, which dramatically
decreases parameter C (carrying cost of one unit) in the EOQ calculation on page 966. Because of close trading partner
relationships, P (relevant ordering costs) in the EOQ calculation can also be reduced despite more frequent ordering. Page
970 provides a list of three factors causing reductions in ordering costs in a J IT purchasing environment. Decreased inventory
may reduce the need for warehousing and some fixed costs, which would also reduce the C component. Because companies
using J IT usually enter into long-term purchasing agreements, J IT may also reduce P or ordering costs. J IT systems can also
have a positive effect on quality because engineers from the buying company often work with the supplier to ensure quality
at the source. E-commerce can increase efficiency and reduce costs of J IT order processing when companies make orders
with online purchasing cards (similar to credit cards).
Potential drawbacks to a J IT system include
problems with quality of inputs when the buyer does not have a backup of material to deal with quality problems
late delivery of materials, which can shut down a manufacturing plant, and
increase in ordering costs resulting from smaller purchase lots, which must be considered in negotiating with
suppliers.
JIT production
J IT production (also called lean production) is a "demand-pull" system. The components of the manufacturing system are
produced immediately before needed by the next link in the supply chain. Here are the main features of a J IT production
system:
Production is organized into manufacturing cells, with machines and equipment grouped together to make a
particular product in a sequential manner.

Workers are trained to be multi-skilled and capable of performing a variety of operations, including maintenance and
repair, which allows greater flexibility.

Defects are aggressively managed through a total quality management (TQM) system, using tight linkages and
minimal inventories. TQM is an essential component of the J IT system.

Setup and manufacturing lead-times are reduced, making production in smaller batches more economically feasible.
Suppliers are selected based on ability to deliver quality products in a timely manner. Dell Canada is a well-known example of
an organization that has implemented a successful J IT production system.
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4.2 Estimating inventory-related costs
Learning objective
Describe the impact of errors in estimating inventory-related costs, and explain the importance of goal congruence.
(Level 2)
Required reading
Chapter 20, pages 973-975
LEVEL 2
Relevant costs are those that change between alternatives. The total annual relevant costs associated with estimating
inventory include
costs that change with varying levels of inventory, such as insurance, property taxes, obsolescence, breakage,
spoilage, rent or storage space (opportunity costs)
salaries and utilities, and
ordering and stockout costs.
It is important to understand that many of these costs do not vary when one more unit of inventory is added. For example, a
company would need to add significant amounts of inventory to increase the property taxes paid in a year or to require
additional warehouse space. Care needs to be taken in estimating these costs; as the following calculations show, however,
the cost difference of a prediction error is usually small.
Estimating total annual relevant inventory costs (TRC) and costs of a prediction error
Refer to Example 4.1-1 and assume that P = $60.00 instead of $40.00. Determining the costs of a prediction error requires
the following steps:
1. Calculate the total annual relevant costs from the best action that could have been taken given the actual amount of
cost input.



TRC = (D/Q) P + (Q/2) C
= (8,000 362) $60.00 + (362 2) $7.35
= $1,326.00 + $1,330.00
= $2,656.00

2. Calculate the total annual relevant costs from the best action on the basis of the incorrect amount of predicted cost
input.

TRC =(D/Q) P + (Q/2) C
=(8,000 295) $60.00 + (295 2) $7.35
=$1,627.00 + $1,084.00
=$2,711.00

3. Calculate the difference between the two total annual relevant costs calculated in steps 1 and 2.

$2,656.00 $2,711.00 = ($55.00) cost of prediction error.
Importance of goal-congruence in inventory management
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Two key opportunity costs are important issues in inventory management stockout costs and carrying costs. For stockout
costs, the contribution margin on lost sales is an opportunity cost. For carrying costs, lost revenue on the investment or cash
tied up in inventory are opportunity costs. These opportunity costs are not usually recorded in the accounting system. The
model used must ensure that the relevant opportunity costs are taken into consideration because if they are not part of
performance evaluation, managers may consider counterproductive decisions. For example, if a purchasing manager were to
be evaluated solely on the basis of no stockouts, that manager would have an incentive to order larger quantities than the
EOQ model suggests is optimal. To create goal congruence, the purchasing manager should be evaluated on a performance
measure that includes the opportunity costs of carrying excessive inventory.
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4.3 Relevance and the JIT strategy of supply-chain management
Updated September 7, 2010, MA2-10-TU04
Learning objective
Describe the role of J IT strategy and supply-chain analysis and management. (Level 2)
Required reading
Chapter 1, pages 5-8 (The Value Chain of Business Functions Leads to the Customer)
Chapter 20, pages 976-980 and page 982 (Real Companies: Challenge: Securing the Benefits of Good Supply-Chain
Management)
Note on the textbook readings
On page 980, the third bullet at the top of the page should read: "Nonfinancial performance measures of time,
inventory, and quality, such as manufacturing lead time, units produced per hours, and days' inventory on hand."
LEVEL 2
Demand and buying behaviours of customers and supply relationships with distributors and manufacturers affect the levels of
inventory held. The term supply chain describes the flow of goods or services and information from raw materials (or the
initiating moment) to the final customer, and often beyond because of recycling initiatives. An example of a supply chain in
the book publishing industry might include forestry operations, paper producers, authors, editors, graphic artists, distributors,
bookstores, paper recycling facilities, and so on. In tourism, a supply chain usually includes travel agents, airlines, hotels and
restaurants, and other tourist destinations.
Supply-chain analysis and management oversees the entire process and flow of goods, services, and information from "womb
to tomb" (creation to disposal), as described in the text on page 6. This includes managing the initial purchase of raw
materials, production and sale of the finished product, after-sales service, and even disposal of the product. For example, Dell
Computers offers a recycling service to purchasers of their computer products.
Increased coordination within a supply chain helps reduce information asymmetry and uncertainty and leads to a better
working relationship, with fewer stockout situations. However, many companies are reluctant to share information for fear of
being eliminated from the supply chain when suppliers or customers integrate the companys processes into their own.
Calculating JIT relevant costs
Exhibit 20-5 (page 977) shows the current relevant costs and J IT relevant costs, and calculates the savings realized in
moving to a J IT purchasing system. Caution should be taken in doing these calculations. Managers should perform a full
sensitivity analysis to show the impact of changes in the important parameters such as stockout and ordering costs.
To illustrate the significant changes that J IT purchasing can have in the costs of purchasing and in the economic order
quantity, work through the following computer illustration.
Computer illustration 4.3-1: Economic order quantity in a JIT operation
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Computer illustration 4.3-1: Economic order quantity in a JIT operation
Kurian Image Maker Ltd. (KIM) designs and manufactures props for Bollywood and Hollywood. An ongoing materials
requirement for KIM is the need for plywood for scenery used to change the exterior and interior of buildings to suit the
script by building shells and fake walls. Baldev Kurian, the vice-president of supply-chain management, is looking at
improving the plywood procurement process. His first step is to determine which suppliers are ISO compliant and to assess
their delivery records, which narrows the suppliers to two. Now he is looking at the costs involved; an analysis of the past
three years provides the following information.
Annual demand for plywood 36,000 sheets
Ordering costs per purchase order $357
Carrying costs per year 16% of purchase cost
Safety stock requirements 10 sheets
Cost per sheet $12.50
The lead time is 3 days. KIM operates and produces goods 365 days a year.
Material provided

File MA2M4P1 containing a partially completed worksheet M4P1 and the solution worksheet M4P1S.
Required
1.



a.



Using the information given in the data table based on the information provided above, determine
the economic order quantity for Kurian Image Makers. What is the total annual relevant cost (TRC)
for purchasing plywood?

b.

What is the re-order point? (See page 968, and remember to include safety stock in the
calculation.)

2.



a.




As KIM uses plywood on a steady basis, Baldev wonders if JIT purchasing might be more cost
effective. If he decides to use JIT, carrying costs will be reduced to 5%. Order costs will rise 10%.
The price per sheet is negotiated annually and will not change. Recalculate the economic order
quantity based on using JIT.

b.

What is the TRC now?


c.

Is JIT a good idea?

Procedure
1. Start Excel.

2. Open the file MA2M4P1. Go to TAB M4P1.

3. Review the spreadsheet. Note that the data table replicates the information given above and is contained between
cells A5 and G20.

4. In cell C24, enter the formula referencing the data table for total demand for part 1.

5. In cell C26, enter the formula for annual carrying costs.

6. In cell C28, enter the formula for order costs.

7. In cell C30, enter the formula for EOQ using the calculated numbers from the previous three steps.

8. In cells E24, E26, E28, and E30 repeat steps 4, 5, 6, and 7 using the J IT information.
Conclusion
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1. a. Demand: 36,000
Carrying costs: $72,000 ($2 per unit)
Order costs: $357
EOQ: 3,585
TRC: $7,170

b.

Re-order point: = 306
2. a. Demand: 36,000
Carrying costs: $22,500 ($0.625 per unit)
Order costs: $392.70
EOQ: 6,726

b. TRC = $4,204

c. The total annual relevant costs are reduced significantly under JIT purchasing from $7,170 to
$4,204. The number of orders goes down as ordering costs increase and carrying costs are
reduced. Baldev should look into the option of using the Internet for placing purchase orders, as
this would simplify the process.

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4.4 MRP and ERP inventory management systems
Learning objective
Describe material requirement planning and enterprise resource planning production systems. (Level 2)
Required reading
Chapter 20, pages 980-982
LEVEL 2
Material requirement planning (MRP) is a "push-through" system that schedules the manufacture of finished goods for
inventory on the basis of expected demand forecasts. Taking into account the lead-time in the production process and other
internal factors such as the bill of materials and available production inventories, managers use this system to provide a
master production schedule for determining output levels required at each stage in the manufacturing process. Although
scheduling and tracking of goods from raw materials to work-in-process and finished goods is a major challenge in successful
implementation of MRP systems, MRP can also lead to increased efficiencies in plant design, labour schedules, and supply-
chain management. Management accountants can use MRP to develop estimates of setup, downtime, and carrying costs to
help develop efficient schedules and determine accurate processing costs.
Enterprise resource planning (ERP) systems integrate accounting, distribution, manufacturing, planning, purchasing,
human-resource and other systems into a single database, which reduces the possibility of errors from running multiple
separate systems and also enhances the ability to plan and coordinate processing activities.
JIT and ERP systems
J IT requires a focus on information flows within the company and between the company and its suppliers/customers. This
process can be aided by an ERP system that links all company information through a centralized database. ERP can link
purchasing, production, accounting, and distribution to provide information that managers use to improve coordination and
reduce overhead costs. These systems can also serve to improve communication between suppliers and customers within the
supply chain.
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Updated October 4, 2010, MA2-10-TU07
4.5 Backflush costing
Learning objective
Prepare journal entries for inventory transactions using backflush costing in a J IT environment. (Level
1)
Required reading
Chapter 20, pages 983-990
LEVEL 1
The unique features of J IT systems lead to changes in the traditional accounting flow because the elimination
of inventories renders decisions about weighted-average or FIFO and absorption or variable costing irrelevant.
Traditional costing systems require sequential tracking using specific trigger points to recognize journal entries
as shown in the following exhibit.
Exhibit 4.5-1: Production cycle using T-accounts

Backflush costing in a J IT environment eliminates some or all journal entries related to the production cycle.
The system then focuses on the production of finished goods, and makes journal entries using either standard
or normal costing. The completion of a finished good triggers journal entries from direct materials and
conversion costs to the finished good. Data for variance analysis can also be simultaneously calculated by
using other systems, such as payroll, within the ERP system. Scrap, rework, and spoilage costs can then be
added to correct any discrepancies and ensure accurate costing.
Different versions of backflush costing result from the setup of different operation and trigger points. Exhibits
20-7 and 20-8 (on pages 986-997) show the journal entries and general ledger overview transaction flow
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under three scenarios. The following example also demonstrates these journal entries under backflush costing.
Example 4.5-1: Accounting flow under backflush costing
Trigger points are stages A, C, and D.
Assume a company has trigger points of purchase for direct materials, completion of finished goods, and sale
of finished goods. Standard costs per unit for direct materials are $22 and conversion costs are $32. The
company produced 10,000 units during the period. Purchases of direct material at standard cost were
$300,000. Actual conversion costs for the period were $310,000. The company had no beginning or ending
inventory balances. Sales were made of 9,000 units at $80 per unit.
1. Record direct material purchased.


2. Record the incurrence of actual conversion costs during period.


3. Compute the budgeted standard cost per unit.

Standard cost = Direct materials ($22) + Conversion costs ($32) = $54 per unit

4. Record finished goods completed during period.


5. Record the sales for the period.


6. Record under-or over-allocated conversion costs.
J IT systems typically include little work-in-process or direct materials inventory, and so they do not require
prorating under- or over-allocated conversion costs (or manufacturing overhead). Companies simply charge
the under- or over-allocated cost to Cost of goods sold.

Note that in this case two conversion cost accounts are used; one to record the actual costs and one to record
the allocated costs. Another method of recording these costs is to simply debit a single conversion cost control
account with actual costs and credit it with applied costs.
Inventory: Raw material and in-process control 300,000
Accounts payable control 300,000
Conversion costs control 310,000
Accounts payable, wages payable 310,000
Finished goods control 540,000
Inventory: Raw and In-Process Control 220,000
Conversion costs allocated 320,000
Cash or accounts receivable 720,000
Revenue 720,000

Cost of goods sold 486,000
Finished goods control 486,000
Conversion costs allocated 320,000
Cost of goods sold 10,000
Conversion cost control 310,000
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Backflush costing, GAAP, and IFRS
The accounting flow under backflush costing does not strictly adhere to GAAP or IFRS for external reporting
purposes. Work in process is not recognized in these examples but it should show up in the inventory
breakdown in the notes to the financial statements. Advocates of backflush accounting argue that because of
the small amount of inventory in Work in process, materiality does not require the breakdown of inventories to
such levels. Critics also point out that there is no audit trail when using backflush accounting.
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4.6 Case: Supply-chain management
Learning objective
Analyze a supply-chain management scenario, and make recommendations. (Level 1)
LEVEL 1
The following data from Welsh Manufacturing Ltd. are provided to give a perspective of supply-chain management.
Case 4.6-1: TQM and JIT at Welsh Manufacturing Ltd.
J ack Hughes, president of Welsh Manufacturing Ltd., is concerned about the increase of production costs for the A45 from
$4.50 per unit six months ago to the current cost of $6.65 per unit. It appears that profit targets for the current year will not
be met. J erry Brice, manager of purchasing agrees to look into the matter.
1. The company uses a normal costing system with budgeted material costs of $1.50 per unit, direct-labour costs of
$2.00 per unit, and manufacturing overhead charged at 50% of direct-labour costs.

2. Eight months ago, J errys department decided to use multiple suppliers so that the company would not be exclusively
tied to one major supplier. Many of the new suppliers are resellers who buy materials from various sources and resell
them to Welsh at a markup.
The company uses a just-in-time production system and therefore work-in-process and finished goods inventories are
negligible.
Required
What additional issues arise when the company uses a just-in-time inventory system?
Solution
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Case: TQM and JIT at Welsh Manufacturing
Solution
That the company uses a just-in-time inventory system places additional pressure on J erry to focus on the suppliers of
product to the A45 product line. The use of resellers as suppliers is a concern; since the product they supply could come from
any number of additional suppliers to the reseller, the probability of manufacturing high-quality products is reduced.
When a company uses a J IT inventory system, the focus is on reducing the number of suppliers, and focusing on quality and
on-time delivery more than on cost. Moving from one supplier to a small number of suppliers is not harmful to the company,
whereas having only one supplier can create additional problems. For example, a difficulty with the supplier, such as a
workers strike or a plant shut-down, would create a shortage of available supply, potentially shutting down Welshs
production line.
J erry needs to gather information about on-time delivery from potential suppliers in choosing which suppliers to work with,
including performing an EOQ analysis. He should also ensure that the suppliers are compliant with international quality
standards.
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Module 4 self-test
Question 1
Exercise 20-16, page 996
Solution
Question 2
Exercise 20-22, pages 997-998
Solution
Question 3
Exercise 20-23, page 998
Solution
Question 4
Exercise 20-24, page 998
Ignore requirement 2.
Solution
Question 5
Problem 20-28, pages 999-1000
Solution
Question 6
Problem 20-31, page 1001
Ignore requirement 2.
Solution
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Self-test 4
Solution 1

20-16 Economic order quantity for retailer

1. D = 10,000, P = $200, C = $7

7
200 $ 000 , 10 2
C
DP 2
EOQ

= = =755.93756jerseys

2. Number of orders per year =
EOQ
D
=
756
000 , 10
= 13.22 14 orders


3.
day working
each Demand
=
days working of Number
D
=
365
000 , 10
= 27.40 jerseys per day

Purchase lead time = 7 days
Reorder point = 27.40 7
= 191.80 192 jerseys

Self-test 4
Solution 2

20-22 Purchase-order size for retailer, EOQ, just-in-time purchasing

1. EOQ =
2DP
C

(a) D = 7,200; P = $36; C = $1.20
EOQ = = =
2(7,200) ($36)
432,000 657.3 cases @658 cases
$1.20

(b) D = 7,200; P = $36; C = $1.80
EOQ =
2(7,200) ($36)
288,000 536.7 cases 537 cases
$1.80
= =
(c) D = 7,200; P = $6; C = $1.80
EOQ =
2(7,200) ($6)
48,000 219.1 cases 220 cases
$1.80
= =

2. A just-in-time purchasing policy involves the purchase of goods such that their
delivery immediately precedes their demand. Given the purchase order sizes
calculated in requirement 1, the number of purchase orders placed each month is (D
EOQ):

(a)
D 7,200

EOQ 658
= = 11 orders per month or 1 every 2.7 days
(b)
D 7,200

EOQ 537
= = 14 orders per month or 1 every 2.15 days
(c)
D 7,200

EOQ 220
= = 33 orders per month or 1 every 0.91 days

An increase in C and a decrease in P led to increases in the optimal frequency of
orders. The 24-Hour Mart has increased the frequency of delivery from every third
day (1a: P = $36; C = $1.20) to a delivery every day (1c: P = $6; C = $1.80). There is a
reduction of 219 cases in the average inventory level: (658 220) 2 = 219.

Self-test 4
Solution 3

20-23 JIT production, relevant benefits, relevant costs

1. Solution Exhibit 20-23 presents the annual net benefit of $315,000 to Champion
Hardware Company of implementing a JIT production system.

2. Other nonfinancial and qualitative factors that Champion should consider in
deciding whether it should implement a JIT system include:
a. The possibility of developing and implementing a detailed system for
integrating the sequential operations of the manufacturing process. Direct
materials must arrive when needed for each subassembly so that the production
process functions smoothly.
b. The ability to design products that use standardized parts and reduce
manufacturing time.
c. The ease of obtaining reliable vendors who can deliver quality direct materials
on time with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time. Failure to do so
would result in customer dissatisfaction.
f. The skill levels of workers to perform multiple tasks such as minor repairs,
maintenance, quality testing, and inspection.

SolutionExhibit2023
AnnualRelevantCostsofCurrentProductionSystemandJITProductionSystemforChampionHardware
Company

RelevantItems
RelevantCosts
underCurrent
Production
System
Relevant
CostsunderJIT
Production
System
Annualtoolingcosts $100,000
Requiredreturnoninvestment:
15%peryear$1,000,000ofaverageinventoryperyear $150,000
15%peryear$200,000
a
ofaverageinventoryperyear 30,000
Insurance,space,materialshandling,andsetupcosts 300,000 225,000
b

Reworkcosts 200,000 140,000

c

Incrementalrevenuesfromhighersellingprices (160,000)
d

Totalnetincrementalcosts $650,000 $335,000

AnnualdifferenceinfavourofJITproduction $315,000

a
$1,000,000 (1 80%) = $200,000
b
$300,000 (1 0.25) = $225,000
c
$200,000 (1 0.30) = $140,000
d
$4 40,000 units = $160,000

Other nonfinancial and qualitative factors that Champion should consider in deciding
whether it should implement a JIT system include the following:
a. The possibility of developing and implementing a detailed system for
integrating the sequential operations of the manufacturing process. Direct
materials must arrive when needed for each subassembly so that the production
process functions smoothly.
b. The ability to design products that use standardized parts and reduce
manufacturing time.
c. The ease of obtaining reliable vendors who can deliver quality direct materials
on time with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time. Failure to do so
would result in customer dissatisfaction.
f. The skill levels of workers to perform multiple tasks such as minor repairs,
maintenance, quality testing, and inspection.

3. Personal observation by production line workers and managers is more effective in
JIT plants than in traditional plants. A JIT plants production process layout is
streamlined. Operations are not obscured by piles of inventory or rework. As a
result, such plants are easier to evaluate by personal observation than cluttered
plants where the flow of production is not logically laid out.

Besides personal observation, nonfinancial performance measures are the

dominant methods of control. Nonfinancial performance measures provide most
timely and easy to understand measures of plant performance. Examples of
nonfinancial performance measures of time, inventory, and quality include:
Manufacturingleadtime.
Unitsproducedperhour.
Machinesetuptimemanufacturingtime.
Numberofdefectiveunitsnumberofunitscompleted.

In addition to personal observation and nonfinancial performance measures,
financial performance measures are also used. Examples of financial performance
measures include:
Costofrework.
Orderingcosts.
Stockoutcosts.
Inventoryturnover(costofgoodssold averageinventory).

The success of a JIT system depends on the speed of information flow from
customers to manufacturers to suppliers. The Enterprise Resource Planning (ERP)
system has a single database, and gives lower-level managers, workers, customers,
and suppliers access to operating information. This benefit, accompanied by tight
coordination across business functions, enables the ERP system to rapidly transmit
information in response to changes in supply and demand so that manufacturing
and distribution plans may be revised accordingly.

Self-test 4
Solution 4

20-24 Backflush costing and JIT production

1.
(a)Purchasesofdirectmaterials Inventory:MaterialsandInProcess
Control 2,754,000

AccountsPayableControl 2,754,000

(b)Incurconversioncosts ConversionCostsControl 723,600

Various Accounts 723,600

(c)Completionoffinishedgoods FinishedGoodsControl
Inventory:MaterialsandInProcess
Control
3,484,000
a

2,733,600
ConversionCostsAllocated 750,400

(d)Saleoffinishedgoods CostofGoodsSold 3,432,000
b

FinishedGoodsControl 3,432,000
a
26,800 ($102 + $28) = $3,484,000
b
26,400 ($102 + $28) = $3,432,000

Omit part 2

3. Under an ideal JIT production system, there could be zero inventories at the end of
each day. Entry (c) would be $3,432,000 finished goods production, not $3,484,000.
Also, there would be no inventory of direct materials instead of $2,754,000
$2,733,600 = $20,400.

Self-test 4
Solution 5

20-28 Effect of different order quantities on ordering costs and

carrying costs, EOQ

1.
Scenario
1 2 3 4 5
Demand(units)(D) 234,000 234,000 234,000 234,000 234,000
Costperpurchaseorder(P) $81.00 $81.00 $81.00 $81.00 $81.00
Annualcarryingcostperpackage(C) $11.70 $11.70 $11.70 $11.70 $11.70
Orderquantityperpurchaseorder(units)(Q) 900 1,500 1,800 2,100 2,700
Numberofpurchaseordersperyear(DQ) 260.00 156.00 130.00 111.43 86.67
Annualorderingcosts(DQ) P $21,060 $12,636 $10,530 $9,026 $7,020
Annualcarryingcosts(QC 2) $5,265 $8,775 $10,530 $12,285 $15,795
Totalrelevantcostsoforderingandcarrying
inventory $26,325 $21,411 $21,060 $21,311 $22,815

The economic order quantity is 1,800 packages. It is the order quantity at which
carrying costs equal ordering costs and total relevant ordering and carrying costs are
minimized.
We can also confirm this from direct calculation. Using D = 234,000; P = $81 and
C = $11.70
EOQ =
70 . 11 $
81 $ 000 , 234 2
=1,800packages
It is interesting to note that Koala Blue faces a situation where total relevant
ordering and carrying costs do not vary very much when order quantity ranges from
1,500 packages to 2,700 packages.

2. When the ordering cost per purchase order is reduced to $49:
EOQ =
70 . 11 $
49 $ 000 , 234 2
=1,400packages
The EOQ drops from 1,800 packages to 1,400 packages when Koala Blues
ordering cost per purchase order decreases from $81 to $49.
The new relevant costs of ordering inventory are:
=

P
Q
D
=

$49
400 , 1
000 , 234
= $8,190
and the new relevant costs or carrying inventory are:

C
2
Q
=

$11.70
2
400 , 1
= $8,190
The total new costs of ordering and carrying inventory = $8,190 2 = $16,380

3. As summarized below, the new Mona Lisa web-based ordering system, by lowering
the EOQ to 1,400 packages, will lower the carrying and ordering costs by $4,680.
Koala Blue will spend $2,000 to train its purchasing assistants on the new system.
Overall, Koala Blue will still save $2,680 in the first year alone.

TotalrelevantcostsatEOQ(fromRequirement2) $16,380
Annualcostbenefitoveroldsystem($21,060$16,380) $4,680
Trainingcosts 2,000
Netbenefitinfirstyearalone $2,680

Self-test 4
Solution 6

20-31 Blackflush costing and JIT production

1.
(a)Purchasesofdirectmaterials Inventory:MaterialsandInProcessControl 550,000
AccountsPayableControl 550,000

(b)Incurconversioncosts ConversionCostsControl 440,000
VariousAccounts 440,000

(c)Completionoffinishedgoods
FinishedGoodsControl
Inventory:Materials&InProcessControl
945,000
a
525,000
ConversionCostsAllocated 420,000

(d)Saleoffinishedgoods CostofGoodsSold 900,000
b
FinishedGoodsControl 900,000
a

21,000 $45 ($25 + $20) = $945,000
b

20,000 $45 = $900,000

Module 4 summary
Make recommendations based on the calculation of total annual relevant costs, economic
order quantity, re-order points, and safety stock levels
The major costs in inventory management are purchasing, ordering, carrying, stockout, and shrinkage costs.



TRC = (D/Q) x P + (Q/2) x C or TRC = (DP/Q) + (QC/2)

Reorder point = Number of units sold (per unit of time) x Purchase order lead time.
Describe the impact of errors in estimating inventory-related costs, and explain the
importance of goal congruence
Relevant costs change based on varying levels of inventory. To determine cost of prediction error requires calculating

TRC from the best action that could have been taken,

TRC from the best action based on the incorrect amount of predicted outlay, and

the difference between the two amounts.
Describe the role of JIT strategy and supply-chain analysis and management
J IT systems purchase goods on a demand-pull basis; materials arrive when they are required.
J IT requires on-time delivery of smaller, more frequent orders.
Benefits of J IT include reduced carrying and ordering costs.
Supply chain describes the flow of goods, services, or information from the raw material or initiating event to the final
customer.
Increased co-ordination within the supply chain helps reduce information asymmetry, leading to better working
relationships and fewer stockout situations.
Need for increased co-ordination can create problems with sharing proprietary information.
Describe materials requirement planning and enterprise resource planning production
systems
Materials requirement planning (MRP) is a push-through system based on expected demand forecasts.
An enterprise resource planning (ERP) system coordinates various functions together and allows managers to integrate
decisions from production planning and scheduling to human resource management to accounting. ERP is a system that
connects the flow of information between all systems in an organization.
Prepare journal entries for inventory transactions using backflush costing in a JIT
environment

Backflush costing eliminates many of the traditional journal entries for inventory throughout the production cycle.

Work in process (WIP) is often the main inventory item that is deleted under backflush costing.

Trigger points for journal entries may be: purchasing raw material, putting finished goods into inventory, and sale of
finished goods.
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The key point is: where an inventory trigger point is not producing a journal entry, it is because the inventory is not
significant.
Analyze a supply-chain management scenario, and make recommendations
It is important to integrate the various concepts that you are learning in the course and use them in real world
situations.
All costing analysis should reflect the needs of the companys overarching strategic plans.
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