ADVANCED MANAGEMENT
ACCOUNTING
Inventory
Management:
Economic Order
Quantity, JIT, and the
Theory of Contraints
2
Learning Objectives
Describe the traditional inventory management
model.
 Describe JIT inventory management.
 Explain the basic concepts of constrained
optimization.
 Describe the theory of constraints, and explain
how it can be used to manage inventory.

3
Inventory, thousands of bricks
Managing Inventories
Inventory
60
Average
Inventory
30
0
3
6
9
12
Weeks
4
The Appropriate Inventory Policy
Two Basic Questions Must be Addressed
How much should be ordered or produced?
 When should the order be placed or the setup
be performed?

5
Inventories

As the firm increases its order size, the number
of orders falls and therefore the order costs
decline. However, an increase in order size also
increases the average amount in inventory, so
that the carrying cost of inventory rises. The
trick is to strike a balance between these two
costs.
6
Basics of Traditional Inventory
Management
Inventory Costs
 Ordering
or Setup Costs
 Carrying Costs
 Stockout Costs
7
Inventory Costs
1.
2.
Ordering Costs: The costs of placing and
receiving an order
Examples: clerical costs, documents, insurance
for shipment, and unloading.
Carrying Costs: The costs of carrying inventory
Examples: insurance, inventory taxes,
obsolescence, opportunity cost of capital tied up
in inventory, and storage.
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Inventory Costs (continued)
3. Stock-Out Costs: The costs of not having sufficient
inventory
Examples: lost sales, costs of expediting (extra setup,
transportation, etc.) and the costs of
interrupted production.
4. Setup Costs: The costs of preparing equipment and
facilities so they can be used to produce a particular
product or component
Examples: setup labor, lost income (from idled
facilities), and test runs. When a firm
produces the goods internally, ordering costs
are replaced by setup costs.
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Traditional Reasons for Carrying Inventory
1. To balance ordering or setup costs and carrying
costs
2. To satisfy customer demand (e.g., meet delivery
dates)
3. To avoid shutting down manufacturing facilities
because of:
a. machine failure
b. defective parts
c. unavailable parts
d. late delivery of parts
10
Traditional Reasons for Carrying
Inventory (continued)
4. Unreliable production processes
5. To take advantage of discounts
6. To hedge against future price increases
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Inventories
Determination of optimal order size
Inventory costs, dollars
Total costs
Carrying costs
Total order costs
Optimal
order size
Order size
12
An Inventory Model
Total Costs = Ordering costs + Carrying cost
TC = PD/Q + CQ/2
whereTC =
The total ordering (or setup) and carrying cost
P = The cost of placing and receiving an order (or the cost
of setting up a production run)
Q = The number of units ordered each time an order is
placed (or the lot size for production)
D = The known annual demand
C = The cost of carrying one unit of stock for one year
Economic order quantity (EOQ) =  2PD/C
13
Inventories
Economic Order Quantity - Order size that
minimizes total inventory costs.
Economic Order Quantity =
2 x annual sales x cost per order
carrying cost
14
Economic-Order-Quantity
Decision Model
The formula for the EOQ model is:
EOQ =
2 DP
C
D = Demand in units for a specified time period
P = Relevant ordering costs per purchase order
C = Relevant carrying costs of one unit in
stock for the time period used for D
15
An EOQ Illustration
EOQ =  2PD/C
D = 1,000 units
Q = 500 units
P = $200 per order
C = $40 per unit
EOQ =  (2 x 200 x 10,000) / 40
EOQ =  10,000
EOQ = 100 units
16
Economic-Order-Quantity
Decision Model
What are the relevant total costs?
 The formula for relevant total costs (RTC) is:
RTC = Annual relevant ordering costs +
Annual relevant carrying costs

RTC =

( )×P+( )
D
Q
Q
2
DP
QC
×C=
+
Q
2
Q can be any order quantity, not just EOQ.
17
Relevant Total Costs (Dollars)
10,000
Economic-Order-Quantity
Decision Model
8,000
Annual relevant
total costs
6,000
5,434
Annual relevant
ordering costs
4,000
2,000
Annual relevant
carrying costs
Order Quantity (Units)
600
988 1,200
EOQ
1,800
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2,400
Considerations in Obtaining
Estimates of Relevant Costs
Obtaining accurate estimates of the cost parameters
used in the EOQ decision model is a challenging
task.
 What are the relevant incremental costs of carrying
inventory?
– Only those costs of the purchasing company that
change with the quantity of inventory held

19
Considerations in Obtaining
Estimates of Relevant Costs

–
–
What is the relevant opportunity cost of capital?
It is the return forgone by investing capital in
inventory rather than elsewhere.
It is calculated as the required rate of return
multiplied by those costs per unit that vary with the
number of units purchased and that are incurred at
the time the units are received.
20
Costs Associated with
Goods for Sale

Five categories of costs associated with goods for
sale are:
1. Purchasing costs
2. Ordering costs
3. Carrying costs
4. Stockout costs
5. Quality costs
21
Reorder Point
When Demand is Certain
Reorder point = Rate of usage x Lead time
Example: Assume that the average rate of usage is 4
units per day for a component. Assume also
that the time required to place and receive an
order is 10 days. What is the reorder point?
Reorder point = 4 x 10 = 40 units
Thus, an order should be placed when inventory drops to
40 units.
22
Reorder Point
When Demand is Uncertain
Reorder point = (Ave. rate of usage x Lead time) +
Safety stock
where:
Safety stock = (Maximum usage - Average usage) x
Lead time
23
Reorder Point (continued)
Example:
Suppose that the maximum usage is 6
units per
day and the
average usage is 4 units per day.
The lead time is 10 days.
What is the reorder point?
Safety stock
Reorder point
= (6 - 4) x 10 = 20 units
= (4 x 10) + 20 = 60 units
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Reorder Point
988
Reorder
Point
Reorder
Point
494
Weeks
1
2
3
4
5
6
7
8
Lead Time
2 weeks
25
Reorder Point (no safety stock)
Reorder point = Rate of usage x Lead time
100
80
ROP
60
40
20
0
Time
26
Safety Stock
Safety stock is inventory held at all times regardless
of the quantity of inventory ordered using the EOQ
model.
 Safety stock is used as a buffer against unexpected
increases in demand or lead time and unavailability
of stock from suppliers.

27
Evaluating Managers and
Goal-Congruence Issues

Goal-congruence issues can arise when there is an
inconsistency between the EOQ decision model
and the model used to evaluate the performance of
the manager implementing the inventory
management decisions.
28
Traditional versus JIT Inventory
Procedures
Inventory Control
System
Traditional Systems
1.
2.
3.
4.
5.
Balance setup and carrying costs
Satisfy customer demand
Avoid manufacturing shutdowns
Take advantage of discounts
Hedge against future price
increases
JIT Systems
1. Drive setup and carrying costs to
zero
2. Use due-date performance
*3. Total preventive maintenance
*4. Total quality control
*5. The Kanban system
*Rather than holding inventories as a hedge against plant-shutdowns,
JIT attacks the plant-shutdown problem by addressing these issues.
29
Just-In-Time Production Systems
Just-in-time (JIT) production systems take a
“demand pull” approach in which goods are only
manufactured to satisfy customer orders.
 Demand triggers each step of the production
process, starting with customer demand for a
finished product at the end of the process, to the
demand for direct materials at the beginning of the
process.

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Materials Requirement
Planning (MRP)
Materials requirements planning (MRP) systems
take a “push-through” approach that manufactures
finished goods for inventory on the basis of demand
forecasts.
 MRP predetermines the necessary outputs at each
stage of production.
 Inventory management is a key challenge in an
MRP system.

31
JIT And Inventory Management
Setup and Carrying Costs: The JIT Approach


JIT reduces the costs of acquiring inventory to
insignificant levels by:
1. Drastically reducing setup time
2. Using long-term contracts for outside
purchases
Carrying costs are reduced to insignificant levels by
reducing inventories to insignificant levels
32
JIT And Inventory Management
Due-Date Performance: The JIT Solution


Lead times are reduced so that the company can
meet requested delivery dates and to respond
quickly to customer demand.
Lead times are reduced by:
– reducing setup times
– improving quality
– using cellular manufacturing
33
JIT And Inventory Management
Avoidance of Shutdown:
The JIT Approach




Total preventive maintenance to reduce machine
failures
Total quality control to reduce defective parts
Cultivation of supplier relationships to ensure
availability of quality raw materials and
subassemblies
The use of the Kanban system is also essential
34
JIT And Inventory Management
Discounts and Price Increases:
JIT Purchasing Versus Holding Inventories


Careful vendor selection
Long-term contracts with vendors
– Prices are stipulated (usually producing a
significant savings)
– Quality is stipulated
– The number of orders placed are reduced
35
Major Features of a JIT System
The five major features of a JIT system are:
 Organizing production in manufacturing cells
 Hiring and retaining multi-skilled workers
 Emphasizing total quality management
 Reducing manufacturing lead time and setup
Time
 Building strong supplier relationships
36
Benefits of JIT Systems

–
–
Benefits of JIT production:
Lower carrying costs of inventory
Eliminating the root causes of rework, scrap, waste,
and manufacturing lead time.
37
Performance Measures and
Control in JIT Production
To manage and reduce inventories, the management
accountant must design performance measures to
control and evaluate JIT production.
 What information may management accountants
use?

–
–
Personal observation by production line workers and
managers
Financial performance measures, such as inventory
turnover ratios
38
Performance Measures and
Control in JIT Production

What are nonfinancial performance measures of
time, inventory, and quality?
– Manufacturing lead time
– Units produced per hour
– Days’ inventory on hand
– Total setup time for machines/Total
manufacturing time
– Number of units requiring rework or scrap/Total
number of units started and completed
39
Backflush Costing
A unique production system such as JIT often leads
to its own unique costing system.
 Organizing manufacturing in cells, reducing defects
and manufacturing lead time, and ensuring timely
delivery of materials enables purchasing,
production, and sales to occur in quick succession
with minimal inventories.

40
Backflush Costing

Where journal entries for one or more stages in the
cycle are omitted, the journal entries for a
subsequent stage use normal or standard costs to
work backward to flush out the costs in the cycle
for which journal entries were not made.
41
Trigger Points
Stage A: Purchase of direct materials
 Stage B: Production resulting in work in process
 Stage C: Completion of a good finished unit or
product
 Stage D: Sale of finished goods

42
Trigger Points



Assume trigger points A, C, and D.
This company would have two inventory accounts:
Type
Combined materials
and materials in work-inprocess inventory
Account Title
1.
Inventory: Material
and In-Process
Control
2. Finished goods
Finished Goods
Control
43
Trigger Points
Assume trigger points A and D.
 This company would have one inventory
account:

Type
Account Title
Combines direct materials
Inventory
inventory and any direct
Control
materials in work-in-process
and finished goods inventories

44
Special Considerations in Backflush
Costing
Backflush costing does not necessarily comply with
GAAP
– However, inventory levels may be immaterial,
negating the necessity for compliance
 Backflush costing does not leave a good audit trail
– the ability of the accounting system to pinpoint the
uses of resources at each step of the production
process

45
What is the Kanban System?
A Card System is used to monitor work-inprocess
 A withdrawal
Kanban
 A production Kanban
 A vendor Kanban
46
The Withdrawal Kanban
Item No.
TVD-114
Item Name LCD Screen
Preceding Process
Computer Assembly
Computer Type Compaq 4/25
Box Capacity 12
Subsequent Process
Box Type AD-1942
Final Assembly
47
The Production Kanban
Item No.
TVD-114
Item Name LCD Screen
Process
Computer Assembly
Computer Type Compaq 4/25
Box Capacity
12
Box Type ___AD-1942
48
The Vendor Kanban
Item No.
TVD-114
Item Name Computer Chassis
Name of Receiving Company
Type Black Plastic
Box Capacity 12
Box Type Cardboard--Type
Time to Deliver
Receiving Gate North Receiving Gate
8:30 A.M., 12:30 P.M., 2:30 P.M.
Name of Vendor Hovey Supply Company
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The Kanban Process
(7)
Withdrawal
Store
Lot with P-Kanban
LCD Assembly
(5) Attach
W-Kanban
(6) Signal
Remove
(4) P-Kanban
Attach to
Post
LCD Screen
Withdrawal
(1)
(1) Remove
W-Kanban
Attach to
Post
(2), (3)
Withdrawal Post
Production
Ordering Post
Final Assembly
50
Multiple Constrained Resource
To the Thurman Company example for a one
constrained resource, add the following additional
constraint: the market limits sales of the economy
disk player to 3,000 units.
Formulate the linear programming problem and
solve using the graphical method Let X1 = deluxe
models and X2 = economy models
Formulation: Max CM = 40X1 + 25X2
Subject to: 4X + 2X2 < 20,000
X2 < 3,000
51
Multiple Constrained Resource
(continued)
X2
10,000
4X1 +2X 2 < 20,000
3,000
D
C
X 2 < 3,000
B
A
5,000
X1
52
Multiple Constrained Resource
(continued)
Corner Point
X1
X2
CM = 40X1 + 25X2
A
0
0
0
B
5,000
0
$200,000
C*
3,500
3,000
$215,000
D
0
3,000
$75,000
* Point C is optimal
The X1 value of point c is found by substituting the second equation into the
first one like so:
$X1 + 2 (3,000) = 20,000
4X1 + 6,000 = 20,000
4X1 =14,000
X1 = 3,500
53
Theory of Constraints
Three Measures of Systems Performance
Throughput
 Inventory
 Operating expenses

54
The Theory of Constraints
(continued)
Five steps to improve performance:
1. Identify an organization’s constraints.
2. Exploit the binding constraints.
3. Subordinate everything else to the decisions
made in Step 2.
4. Elevate the organization’s binding constraints.
5. Repeat the process as a new constraint emerges
to limit output.
55
Theory of Constraints
A sequential process of identifying and removing
constraints in a system.
Restrictions or barriers that impede
progress toward an objective
56
Theory of Constraints

The theory of constraints emphasizes the
management of bottlenecks as the key to improving
the performance of the production system as a
whole.
57
Methods to Relieve Bottlenecks
Eliminate idle time at the bottleneck operation
 Process only those parts or products that increase
throughput contribution, not parts or products that
will remain in finished goods or spare parts
inventories
 Shift products that do not have to be made on the
bottleneck operation to nonbottleneck processes, or
to outside processing facilities

58
Methods to Relieve Bottlenecks
Reduce setup time and processing time at
bottleneck operations
 Improve the quality of parts or products
manufactured at the bottleneck operation

59
Theory of Constraints
The objective of TOC is to increase throughput
contribution while decreasing investments and
operating costs.
 TOC considers a short-run time horizon and
assumes operating costs to be fixed costs.

60
The Drum-Buffer-Rope System
Raw Materials
Initial Process
Rope
Process C
Process A
Final Process
Process B
Finished Goods
Time
Buffer
Drummer Process
61
The Management of Capacity

Managers can reduce capacity-based fixed costs
by measuring and managing unused capacity

Unused Capacity is the amount of productive
capacity available over and above the productive
capacity employed to meet consumer demand in
the current period
62
Analysis of Unused Capacity

Two Important Features:
1. Engineered Costs result from a cause-and-effect
relationship between output and the resources
used to produce that output
2. Discretionary Costs have two parts:
1. They arise from periodic (annual) decisions
regarding the maximum amount to be incurred
2. They have no measurable cause-and-effect
relationship between output and resources
used
63
Managing Unused Capacity
Downsizing (Rightsizing) is an integrated
approach of configuring processes, products,
and people to match costs to the activities that
need to be performed to operate effectively and
efficiently in the present and future
 Because identifying unused capacity for
discretionary costs is difficult, downsizing, or
otherwise managing this unused capacity, is
also difficult.

64
End of Week
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