Inventory Management,
Just-in-Time, and
Backflush Costing
Chapter 20
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Learning Objective 1
Identify five categories of costs
associated with goods for sale.
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Costs Associated with
Goods for Sale
1. Purchasing costs include transportation costs.
2. Ordering costs include receiving and
inspecting the items in the orders.
3. Carrying costs include the opportunity cost
of the investment tied up in inventory and
the costs associated with storage.
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Costs Associated with
Goods for Sale
4. Stockout costs occur when an organization
runs out of a particular item for which
there is a customer demand.
5. Quality costs of a product or service is its lack
of conformance with a prespecified standard.
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Learning Objective 2
Balance ordering costs with
carrying costs using the
economic-order-quantity
(EOQ) decision model.
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Economic-Order-Quantity
Decision Model Assumptions
1. The same quantity is ordered at each
reorder point.
2. Demand, ordering costs, carrying costs,
and purchase-order lead time are
known with certainty.
3. Purchasing costs per unit are unaffected
by the quantity ordered.
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Economic-Order-Quantity
Decision Model Assumptions
4. No stockouts occur.
5. Quality costs are considered only to the
extent that these costs affect ordering
costs or carrying costs.
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Economic-Order-Quantity
Decision Model Assumptions
The EOQ minimizes the relevant ordering
costs and carrying costs.
Video store sells packages of blank video tapes.
Video purchases packages of video tapes from
Oaks, Inc., at $15/package.
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Economic-Order-Quantity
Decision Model Assumptions
Annual demand is 12,844 packages, at the
rate of 247 packages per week.
Video requires a 15% annual return on investment.
The purchase-order lead time is two weeks.
What is the economic-order-quantity?
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Economic-Order-Quantity
Decision Model Assumptions
Relevant ordering cost per purchase order: $209
Relevant carrying costs per package per year:
Required annual ROI (15% × $15)
$2.25
Relevant other costs
3.25
Total
$5.50
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Economic-Order-Quantity
Decision Model Example
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
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Economic-Order-Quantity
Decision Model Example
EOQ =
2x128
, 44x$209
$5
.50
976,144 =
988 packages
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Economic-Order-Quantity
Decision Model Example
What are the relevant total costs (RTC)?
RTC = Annual relevant ordering costs
+ Annual relevant carrying costs
D
Q
RTC = Q × P + 2 × C
or
DP QC
+
Q
2
Q can be any order quantity, not just the EOQ.
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Economic-Order-Quantity
Decision Model Example
When Q = 988 units,
RTC = (12,844 × $209 ÷ 988) + (988 × $5.50 ÷ 2)
= $5,434 total relevant costs
How many deliveries should occur each time period?
D
12,844
=
=
13
deliveries
EOQ
988
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Relevant Total Costs (Dollars)
10,000
Economic-Order-Quantity
Decision Model Example
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
2,400
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Reorder Point
Reorder point
= Number of units sold per unit of time
× Purchase-order lead time
EOQ = 988 packages
Number of units sold/week = 247
Purchase-order lead time = 2 weeks
Reorder point = 247 × 2 = 494 packages
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Reorder Point
988
Reorder
Point
Reorder
Point
494
Weeks
1
2
3
4
Lead Time
2 weeks
5
6
7
8
Lead Time
2 weeks
This exhibit assumes that demand and purchase-order lead time are certain:
Demand = 247 tape packages/week
Purchase-order lead time = 2 weeks
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Safety Stock Example
Safety stock is inventory held at all times
regardless of the quantity of inventory
ordered using the EOQ model.
Video’s expected demand is 247 packages per week.
Management feels that a maximum demand of
350 packages per week may occur.
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Safety Stock Example
How much safety stock should be carried?
350 Maximum demand – 247 Expected demand
= 103 Excess demand per week
103 packages × 2 weeks lead time
= 206 packages of safety stock.
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Considerations in Obtaining
Estimates of Relevant Costs
What are the relevant incremental costs
of carrying inventory?
– only those costs of the purchasing company
that change with the quantity of inventory held
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Cost of Prediction Error
Predicting relevant costs requires care
and is difficult.
Assume that Video’s relevant ordering cost
is $97.84 instead of the $209 prediction used.
What is the cost of this prediction error?
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Cost of Prediction Error
Step 1: Compute the monetary outcome
from the best action that could have been
taken, given the actual amount of the cost input.
EOQ =
EOQ =
2x128
, 44x978
.4
$5.50
456
,966= 676 packages
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Cost of Prediction Error
The annual relevant total costs when EOQ is
676 packages is:
DP QC
RTC =
+
Q
2
RTC = (12,844 × $97.84 ÷ 676) + (676 × $5.50 ÷ 2)
= $3,718 total relevant costs
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Cost of Prediction Error
Step 2: Compute the monetary outcome
from the best action based on the incorrect
amount of the predicted cost input.
EOQ =
2x128
, 44x$209
= 988 packages
$5.50
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Cost of Prediction Error
What are the annual relevant costs using
this order quantity when
D = 12,844 units, P = $97.84, and C = $5.50?
RTC = (12,844 × $97.84 ÷ 988) + (988 × $5.50 ÷ 2)
= $ 3,989 total relevant costs
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Cost of Prediction Error
Step 3: Compute the difference between
the monetary outcomes from Steps 1 & 2.
Step 1
$3,718
Step 2
3,989
Difference
$ (271)
The cost of prediction error is $271.
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Learning Objective 3
Identify and reduce conflicts
that can arise between EOQ
decision model and models used
for performance evaluation.
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Evaluating Managers and
Goal-Congruence Issues
The opportunity cost of investment tied up
in inventory is a key input in the
EOQ decision model.
Some companies now include opportunity
costs as well as actual costs when
evaluating managers.
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Just-In-Time Purchasing
Just-in-time (JIT) purchasing is the purchase
of goods or materials such that a delivery
immediately precedes demand or use.
Companies moving toward JIT purchasing
argue that the cost of carrying inventories
(parameter C in the EOQ model) has been
dramatically underestimated in the past.
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JIT Purchasing and EOQ
Model Parameters
The cost of placing a purchase order
(parameter P in the EOQ model) is
also being re-evaluated.
Three factors are causing sizable reduction
in the cost of placing a purchase order (P).
1. Companies increasingly are establishing
long-run purchasing arrangements.
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JIT Purchasing and EOQ
Model Parameters
2. Companies are using electronic links,
such as the Internet, to place purchase orders.
3. Companies are increasing the use of
purchase order cards (similar to consumer
credit cards like Visa and Master Card).
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Learning Objective 4
Use a supply-chain approach
to inventory management.
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Supply-Chain Analysis
Supply-chain analysis describes the flow
of goods, services, and information from
cradle to grave, regardless of whether
those activities occur in the same
organization or other organizations.
“bullwhip effect” or “whiplash effect”
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Learning Objective 5
Differentiate materials
requirements planning (MRP)
systems from just-in-time (JIT)
systems for manufacturing.
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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.
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Materials Requirement
Planning (MRP)
Management accountants play key roles in
an MRP system, including...
– maintaining accurate and timely information
pertaining to materials, work in process,
and finished goods, and...
– providing estimates of the setup costs for each
production run, the downtime costs,
and carrying costs of inventory.
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Learning Objective 6
Identify the features of a
just-in-time production system.
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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.
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Major Features of a JIT System
1. Organizing production in manufacturing cells
2. Hiring and retaining multi-skilled workers
3. Emphasizing total quality management
4. Reducing manufacturing lead time and setup time
5. Building strong supplier relationships
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Major Features of a JIT System
What information may management accountants use?
Personal observation by production
line workers and managers
Financial performance measures,
such as inventory turnover ratios
Nonfinancial performance measures
of time, inventory, and quality.
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End of Chapter 20
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