Inventory Management, Just-In-Time, and

Backflush Costing

National Chengchi University

2007.5.23

1 Economic-Order-Quantity Decision Model

Inventory management includes planning, coordinating, and controlling ac-
tivities related to the flow of inventory into, through, and out of an organiza-
tion. Costs associated with goods for sale:

1. Purchasing costs — the cost of goods acquired from suppliers, including

incoming freight costs. Discounts for various purchase-order sizes and
supplier credit terms affect purchasing costs.

2. Ordering costs — the costs of preparing and issuing purchase orders, re-
ceiving and inspecting the items included in the orders, and matching
invoices received, purchase orders, and delivery records to make pay-
ments.

3. Carrying costs — the costs that arise while holding an inventory of goods
for sale. Carrying costs include the opportunity cost of the investment
tied up in inventory and the costs associated with storage, such as space
rental, insurance, obsolescence, spoilage, and shrinkage (resulting from
theft).

4. Stockout costs — the costs that result when a company runs out of a
particular item for which there is customer demand – a stockout – and the
company must act quickly to meet that demand or suffer the costs of not
meeting it.

5. Quality costs — the costs that result when features and characteristics of
a product or service are not in conformance with customer specifications
(refer to Chapter 19).

The economic order quantity (EOQ) is a decision model that, under a given
set of assumptions, calculates the optimal quantity of inventory to order. The
assumptions are

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 1. The same quantity ( Q) is order at each reorder point.

2. Demand ( D ), ordering cost ( P), and carrying costs (C ) are know with
certainty.

3. The purchase-order lead time (the time between placing an order and its
delivery) is known.

4. Purchasing cost per unit is unaffected by the quantity ordered.

5. No stockputs occur (i.e., the costs of stockouts are so high that managers
maintain adequate inventory to prevent them).

6. In deciding on EOQ, managers consider cost of quality only to the extent

that these costs ordering or carrying costs.

The relevant total cost ( RTC ) is:1

   
D Q C
RTC = min ×P + ×C = min DPQ−1 + Q (1)
Q Q 2 Q 2

r
∂RTC C 2DP
= − DPQ−2 + = 0 ⇒ EOQ =
∂Q 2 C

Example 1: D = 13, 000, C = $5.20, P = $200.

Answer:q
EOQ = 2×13,000
$5.20
×$200
= 1, 000. RTC = 13,000×$200
1,000 + 1,000×2 $5.20 = $5, 200 ♣

The EOQ model is about how much to order of a given prodcut. The second
decision in managing goods for sale is when to order a given product.
The reorder point is the quantity level of inventory on hand that triggers a
new purchase order:

Reorder point = Number of units sold per unit of time × Purchase-order

lead time.

Example 2: EOQ = 1, 000, Number of units sold per week 13, 000 ÷ 52 = 250
packages per week, Purchase-order lead time: 2 weeks.

Answer: Reorder point = 250 × 2 = 500 (packages) ♣

1 Please check the second order condition by yourself.

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 Safety stock is inventory held at all times regardless of the quantity of in-
venotry ordered using the EOQ model. Safety stock is used as a buffer against
unexpected increases in demand, uncertainty about lead time, and unavail-
ablity of stock from suppliers.

CASE 1: Safety stock (note that the relevant stockout costs in this case are $4
per package).
Answer: Exhibit 20-3. ♣

Example 3: Cost of a prediction error: D = 13, 000, C = $5.20, Pestimated = $200,

P actual = $100.
Answer:
q
1. The ”best” action could be, given P actual : EOQ = 2×13,000 ×$100
$5.20 = 707
13,000×$100 707×$5.20
2. RTCbest action = 707 + 2 = $3, 677
13,000×$100 1,000×$5.20
3. RTC predicted = 1,000 + 2 = $3, 900

4. Cost of the prediction error = $3, 900 − $3, 677 = $223

2 Just-in-Time Purchasing
Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that
they are delivered just as needed for production (or sales). Companies moving
toward JIT purchasing is to reduce their costs of carrying inventories (parame-
ter C in the EOQ model). At the same time, the cost of placing a purchase order
(parameter P in the model) is decreasing because:

• Companies are establishing long-term purchasing aggrements that de-

fine price and quality terms over an extended period.

• Companies are using electronic links, such as the Internet, to place pur-
chase orders at a cost that is estimated to be a small fraction of the cost of
placing orders by telephone or by mail.

• Companies are using purchase-order cards.2 As long as purchasing per-

sonnel stay within preset total and individual-transaction dollar limits,
traditional labor-intensive procurement-approval procedures are not re-
quired.
2 It is similar to consumer credit cards such as VISA and MasterCard.

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Example 4: A sensitivity of EOQ model.
Answer:
C P = $200 P = $150 P = $100 P = $30

$5.2 EOQ = 1, 000 EOQ = 866 EOQ = 707 EOQ = 387

7.00 862 746 609 334
10.00 721 624 510 279
15.00 589 510 416 228

CASE 2: Relevant costs of JIT purchasing (page 661∼662)

Answer: Exhibit 20-5. ♣

CASE 3: Supplier evaluation and relevant costs of quality and timely delivers
(page 662∼663)
Answer: Exhibit 20-6. ♣

3 MRP and JIT Production

Materials requirements planning (MRP) is a “push-through” system that man-
ufactures finished goods for inventory on the basis of demand forecasts. MRP
uses:

1. demand forecasts for final products;

2. a bill of materials detailing the materials, components, and subassemblies

for each final product; and

3. the quantities of materials, components, and product inventories to de-

termine the necessary outputs at each stage of production.

Just-in-time (JIT) production, which is also called lean production, is a “demand-

pull” manufacturing system that manufactures each component in a produc-
tion line as soon as, and only when, needed by the next step in the production.
JIT production systems aim to simultaneously (1) meet customer demand in a
timely way, (2) with high-quality products, and (3) at the lowest possible total
cost.
A JIT production system has these features:

• Production is organized in manufacturing cells, a grouping of all the dif-

ferent types of equipment used to make a given product.

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 • Workers are hired and trained to be multiskilled and capable of perform-
ing a variety of operations and tasks, including minor repairs and routine
maintenance of equipment.

• Defects are aggressively eliminated. Because of the tight links between

workstations in the production line and the minimal inventories at each
workstation, defects arising at one workstation quickly affect other work-
stations in the line. JIT creates an urgency for solving problems immedi-
ately and eliminating the root causes of defets as quickly as possible.

• Setup time is reduced.

• Suppliers are selected on the basis of their ability to deliver quality ma-
terials in a timely manner. Most companies implementing JIT production
also implement JIT purchasing.

The success of JIT production system hinges on the speed of information

flows from customers to manufacturers to suppliers. The Enterprise Resource
Planning (ERP) system comprises a single database that collects data and feeds
it into software applications supporting all of a company’s business activities.
The performance measures and control in a JIT production:

1. Financial performance measures, such as inventory turnover ratio,3 which

is expected to be imporved.

2. Nonfinancial performance measures of time, invenotry, and quality, su

as:

• manufacturing lead time, expected to decrease

• units produced per hour, expected to increase
• number of days of inventory on hand, expected to decrease
Total setup time for machine
• Total manufacturing time , expected to decrease
Number of units requiring rework or scarp
• Total number of units started and completed , expected to decrease

4 Backflush Costing
Traditional normal and standard-costing systems use sequential tracking, which
is a costing system in which recording of the journal entries occurs in the same
order as actual purchases and progress in production.
3 Cost of goods sold ÷ Average invenotry

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 Stage Process Example I Example II Example III

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√ √
A Purchase of DM
B Result in WIP†
√ √
C Finished Goods
√ √ √
D Sales
Account Title Inventory: Materials and In-Process Control Inventory Control Inventory Control
Finished Goods Control
page 670 page 674 page 675
† No entries in Stage B.
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5 Exhibits

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