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ADVANCED MANAGEMENT ACCOUNTING

ADVANCED MANAGEMENT ACCOUNTING. Inventory Management: Economic Order Quantity, JIT, and the Theory of Contraints. Learning Objectives. Describe the traditional inventory management model. Describe JIT inventory management. Explain the basic concepts of constrained optimization.

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ADVANCED MANAGEMENT ACCOUNTING

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  1. ADVANCED MANAGEMENT ACCOUNTING

  2. Inventory Management: Economic Order Quantity, JIT, and the Theory of Contraints

  3. 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.

  4. Managing Inventories Inventory 60 30 Inventory, thousands of bricks Average Inventory 0 3 6 9 12 Weeks

  5. 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?

  6. 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.

  7. Ordering or Setup Costs Carrying Costs Stockout Costs Basics of Traditional Inventory Management Inventory Costs

  8. Inventory Costs • 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.

  9. 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.

  10. 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

  11. Traditional Reasons for Carrying Inventory (continued) 4. Unreliable production processes 5. To take advantage of discounts 6. To hedge against future price increases

  12. Inventories Determination of optimal order size Total costs Carrying costs Inventory costs, dollars Total order costs Order size Optimal order size

  13. An Inventory Model Total Costs = Ordering costs + Carrying cost TC = PD/Q + CQ/2 where TC = The total ordering (or setup) and carrying cost P = The cost of placing and receiving an order (or the cost of setting up aproduction 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

  14. Inventories Economic Order Quantity - Order size that minimizes total inventory costs.

  15. Economic-Order-Quantity Decision Model The formula for the EOQ model is: EOQ = 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

  16. 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

  17. 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 + () × C = + • Q can be any order quantity, not just EOQ. QC 2 D Q Q 2 DP Q

  18. Economic-Order-Quantity Decision Model 10,000 8,000 Annual relevant total costs Relevant Total Costs (Dollars) 6,000 5,434 Annual relevant ordering costs 4,000 Annual relevant carrying costs 2,000 600 988 EOQ 1,200 1,800 2,400 Order Quantity (Units)

  19. 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

  20. 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 thosecosts per unit thatvary with the number of units purchased and that are incurred at the time the units are received.

  21. Costs Associated with Goods for Sale • Five categories of costs associated with goods for sale are: • . Purchasing costs • . Ordering costs • . Carrying costs • . Stockout costs • . Quality costs

  22. Reorder PointWhen 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.

  23. Reorder PointWhen Demand is Uncertain Reorderpoint = (Ave. rate of usage x Lead time) + Safety stock where: Safety stock = (Maximum usage - Average usage) x Lead time

  24. 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 = (6 - 4) x 10 = 20 units Reorder point = (4 x 10) + 20 = 60 units

  25. Reorder Point 988 Reorder Point Reorder Point 494 Weeks 1 2 3 4 5 6 7 8 Lead Time 2 weeks

  26. Reorder Point (no safety stock) Reorder point = Rate of usage x Lead time 100 80 60 40 20 0 ROP Time

  27. 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.

  28. 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.

  29. Traditional versus JIT Inventory Procedures Inventory Control System Traditional Systems JIT Systems 1. Balance setup and carrying costs 2. Satisfy customer demand 3. Avoid manufacturing shutdowns 4. Take advantage of discounts 5. Hedge against future price increases 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.

  30. 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.

  31. 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.

  32. 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

  33. 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

  34. 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

  35. JIT And Inventory ManagementDiscounts 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

  36. 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 setupTime • Building strong supplier relationships

  37. Benefits of JIT Systems • Benefits of JIT production: • Lower carrying costs of inventory • Eliminatingthe root causes of rework, scrap, waste, and manufacturing lead time.

  38. 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

  39. 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

  40. 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.

  41. 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.

  42. 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

  43. Trigger Points • Assume trigger points A, C, and D. • This company would have two inventory accounts: • Type Account Title 1. Combined materials Inventory: Material and materials in work-in- and In-Process process inventory Control 2. Finished goods Finished GoodsControl

  44. 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

  45. 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

  46. A withdrawal Kanban A production Kanban A vendor Kanban What is the Kanban System? A Card System is used to monitor work-in-process

  47. The Withdrawal Kanban Item No. TVD-114 Preceding Process Item Name LCD ScreenComputer Assembly Computer Type Compaq 4/25 Box Capacity 12 Subsequent Process Box Type AD-1942Final Assembly

  48. The Production Kanban Item No. TVD-114 Process Item Name LCD Screen Computer Assembly Computer Type Compaq 4/25 Box Capacity 12 Box Type ___AD-1942

  49. The Vendor Kanban Item No. TVD-114 Name of Receiving Company Item Name Computer Chassis Type Black Plastic Box Capacity 12 Box Type Cardboard--TypeReceiving Gate North Receiving Gate Time to Deliver 8:30 A.M., 12:30 P.M., 2:30 P.M. Name of Vendor Hovey Supply Company

  50. The Kanban Process (7) Withdrawal Store (1) Lot with P-Kanban LCD Assembly (1) Remove W-Kanban Attach to Post (5) Attach W-Kanban (6) Signal Remove (4) P-Kanban Attach to Post LCD Screen Withdrawal (2), (3) Withdrawal Post Production Ordering Post Final Assembly

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