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CH 20 IM11 e
CH 20 IM11 e
LEARNING OBJECTIVES
1. Identify five categories of costs associated with goods for sale
2. Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model
3. Identify and reduce conflicts that can arise between EOQ decision model and models used for
performance evaluation
5. Differentiate materials requirements planning (MRP) systems from just-in-time (JIT) systems for
manufacturing
8. Describe different ways backflush costing can simplify traditional job-costing systems
CHAPTER OVERVIEW
Chapter 20 looks at a specific aspect of accounting for productsthat of inventory. Both the accounting
for products from the perspective of the retailer as well as that of the manufacturer are examined.
Resources represented by inventory account for the largest cost in many retail companies. Managers
understand the effect they have upon profitability. Management accountants provide necessary
information for the managing of inventory. Basic types of information are described within the chapter:
types of costs associated with inventory, key decisions about managing goods, challenges in estimating
costs and their effects, and manufacturing systems to better manage inventory. The two key questions for
a retailer for managing inventory are those of how much to order and when to order. These same
questions are crucial for a manufacturer but are placed in terms of the supply chain with the manufacturer
dependent upon that retailer, causing some differences in how to manage under conditions of uncertainty.
The chapter provides a look at the accounting system for manufacturing products using a just-in-time
(JIT) processing system. The manufacturing system is described and the accounting for such a system is
detailed using the concept of backflush costing. This study provides another example of how the
accounting system describes the underlying operations for the manufacturing of a product. The just-in-
time system is compared to the system of materials requirements planning (MRP), a push-through
systems as opposed to the demand-pull system of JIT. A section on Enterprise Resource Planning has
been added. These systems are examined by their effect(s) on inventories managed by a company.
B. Materials costs often account for more than 40% of total costs in manufacturing companies and
more than 70% of total costs in retail companies
A. Inventory management: the planning, coordinating, and control activities related to the flow of
inventory into, through, and from an organization
1. Costs of goods sold is largest single cost item for some retailers
2. Better decisions regarding the purchasing and managing of goods for sale can cause large
percentage increases in net income when net income is small percentage of revenues
Learning Objective 1:
Identify five categories of costs associated with goods for sale
1. Purchasing costs: costs of goods acquired from suppliers including incoming freight or
transportation costs
b. Affected by discounts for different purchase-order sizes and supplier credit terms
2. Ordering costs: include costs of preparing purchase orders and receiving goods
b. Include costs associated with storage (space rental, insurance, obsolescence, spoilage)
4. Stockout costs: costs arising when a customer demands a unit of product and that unit is not
on hand
14 Chapter 20
6. Advances in information-gathering technology increasing reliability and timeliness
Learning Objective 2:
Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model
a. Economic order quantity (EOQ): decision model that calculates optimal quantity of
inventory to order under a set of assumptions (balancing ordering and carrying costs)
ii. Demand, ordering costs, and carrying costs known with certainty as is purchase-
order lead time: time between placing an order and its delivery
v. Quality costs only considered to extent they affect ordering or carrying costs
2DP
b. EOQ formula: EOQ
C
iii. C = relevant carrying costs of one unit stock for the time period used for D
iv. EOQ increases with demand and ordering costs/decreases with carrying costs
c. Annual relevant total costs (RTC) for any order quantity formula
D Q DP QC
i. RTC = x P + x C = + [Exhibit 20-1]
Q 2 Q 2
ii. Annual relevant costs at minimum amount where relevant ordering costs and relevant
carrying costs are equal (EOQ)
i. Definition: quantity level of the inventory on hand that triggers a new order
ii. Formula: Reorder point = Number of units sold per unit of time x Purchase-order
lead time [Exhibit 20-2]
i. Definition: Inventory held at all times regardless of the quantity of inventory ordered
using the EOQ model
ii. Used as a buffer against unexpected increases in demand, uncertainty about lead time
and unavailability of stock from suppliers
iv. Computed to minimize sum of annual relevant stockout costs and carrying costs
2. Cost of prediction error: when actual relevant costs differ from the estimated relevant cost for
decision making
i. Step 1: Compute the monetary outcome from the best action that could be taken,
given the actual amount of the cost input
ii. Step 2: Compute the monetary outcome from the best action based on the incorrect
amount of the predicted cost input
iii. Step 3: Compute the difference between the monetary outcomes from steps 1 and 2
16 Chapter 20
b. Square root in EOQ model reduces sensitivity of the ordering decision to errors in
predicting its parameters
Learning Objective 3:
Identify and reduce conflicts that can arise between EOQ decision model and models used for
performance evaluation
1. Opportunity cost of investment tied up in inventory a key input in EOQ decision model
3. Can include opportunity costs when evaluating managers, so EOQ decision model consistent
with performance evaluation model
Do multiple choice 2 6. Assign Exercises 20-16, 17, 18, 19, 20, and Problems 20-26, 27, 28.
A. Definition: purchase of goods or materials so that delivered just as needed for production
a. Reduction in cost due to long-run purchasing arrangements defining price and quality
terms over an extended period
c. Reduction in cost due to use of purchase order cards that do not require traditional labor-
intensive procurement approval mechanisms
3. EOQcombination of relevant carrying costs increasing and relevant ordering costs per
purchase order decreasing [Exhibit 20-4]
a. EOQ model designed to only emphasize trade-off between carrying costs and ordering
costs
b. Inventory management includes purchasing costs, stockout costs, and quality costs
3. Consideration of relevant costs of quality and also the relevant costs of failing to deliver on
time
Assign Exercises 20-21 and 20-22 and Problems 20-29 and 20-30.
Learning Objective 4:
Use a supply-chain approach to inventory management
A. Level of inventories held by retailers influenced by demand patterns of customers and supply
relationships with distributors, manufacturers, and suppliers to suppliers and so on
1. Flow of goods, services, and information from initial sources of materials and services to
delivery of products to consumerssupply chain [Chapter 1, Enhancing the Value of
Management Accounting Systems, Exhibit 1-5]
3. Supply chain approach allows companies to coordinate their activities and reduce inventories
through the supply chainsome companies have supplier or vendor-managed inventory
18 Chapter 20
Learning Objective 5:
Differentiate materials requirements planning (MRP) systems from just-in-time (JIT) systems for
manufacturing
ii. Output of each department pushed through the production line whether it is needed or
not
ii. Management accountant also helps in estimates of setup cost for production lines
Costs of setting up matched with size of batches to balance costs of setups with
costs of carrying inventory (large costs, large batch sizes or small costs, small
batch sizes)
Costs of downtime matched with running time of production line (high downtime
costs, continuous production)
ii. Demand-pull feature achieves close coordination among workstations in the process
Learning Objective 6:
Identify the features of a just-in-time production system
i. Comprises a single database that collects and feeds data into applications supporting
all of a companys business activities
iii. Heightened emphasis on eliminating specific causes of rework, scrap, and waste
20 Chapter 20
e. Performance measures and control in JIT production
iv. Feedback that is rapid and meaningful necessary to detect and solve problems
quickly due to lack of buffer from inventories
Do multiple choice 7.
C. Backflush costing: job costing system that dovetails with JIT production
Learning Objective 7:
Use backflush costing
1. Backflush costing: costing system that omits recording some or all of the journal entries
relating to the cycle from purchase of direct materials to the sale of finished goods
b. Rapid conversion of direct materials into finished goods that are immediately sold
simplifies job costing; JIT production leads to large reduction in work in process
Learning Objective 8:
Describe different ways backflush costing can simplify traditional job-costing systems
a. Traditional systems use sequential tracking to track costs sequentially as products pass
through four stages in a cycle going from purchase of direct materials to sale of finished
goods
b. Trigger point: refers to a stage in the cycle going from purchase of direct material (Stage
A) to sale of finished goods (Stage D) at which journal entries are made in the accounting
system
ii. Example 2 with two trigger points [Exhibits 20-7 and 8, Panel B]
iii. Example 3 with two trigger points [Exhibits 20-7 and 8, Panel C]
i. Two inventory accounts: (1) Materials and In-Process and (2) Finished Goods
Step 1: Record the direct materials purchased during the accounting period
22 Chapter 20
Step 3: Determine the number of good finished units manufactured during the
accounting period
Step 5: Record the cost of good finished goods completed during the accounting
period
Output trigger point reaches back and pulls standard costs into entry
Step 6: Record the cost of goods sold during the accounting period
iv. Accounting for variancesbasically same under all standard costing systems
b. Example 2: Costs reported similarly to sequential tracking when WIP and finished goods
minimal
c. Example 3: Costs reported similarly to sequential tracking when direct materials and
WIP minimal
i. Could be used with only one trigger pointStage D: Sale of finished goods
ii. Could be used with only one trigger pointStage D: Sale of finished goods
maintains no inventory accounts so used with JIT system with minimal inventories
i. Simplifying production process makes more of the costs direct and reduces extent of
overhead cost allocations
ii. Using ABC systems gives more accurate budgeted conversion costs per unit for
different products in backflush costing
Do multiple choice 8 10. Assign Exercise 20-23, 24, 25, and Problems 20-33, 34, 35, and 36.
CHAPTER QUIZ SOLUTIONS: 1.b 2.d 3.b 4.a 5b. 6.a 7.b 8.d 9.d 10.c
24 Chapter 20
CHAPTER QUIZ
1. Which of the following categories of costs are important when managing inventories of goods for sale
according to the authors of the text?
2. [CMA Adapted} If Liberty Celebrations does not maintain a safety stock, the estimated total carrying
cost for the flag displays for the coming year is
3. [CMA Adapted] The estimated total setup cost for the flag displays for the coming year is
4. [CMA Adapted] If Liberty Celebrations were to schedule 30 equal production runs of the flag display
for the coming year, instead of 60 equal runs, the sum of carrying costs and setup costs for the coming
year would increase (decrease) by
5. [CMA Adapted] The number of production runs per year of the flag displays that would minimize the
sum of carrying costs and setup costs for the coming year is
6. [CMA Adapted] A safety stock of a 3-day supply of flag displays would increase Liberty
Celebrations planned average inventory in units by
d. No entry.
26 Chapter 20
WRITING/DISCUSSION EXERCISES
1. Identify five categories of costs associated with goods for sale
Compare costs included for Cost of Goods Sold in financial accounting with costs
associated with goods for sale in the chapter. In financial accounting, costs included in the
Cost of Goods Sold section of a multiple-step income statement would be the purchase costs as
described in this chapter. The other four categories of ordering costs, carrying costs, stockout costs, and
quality costs would not be found within the Cost of Goods Sold category for financial accounting.
Ordering and carrying costs would be included in operating expense. Stockout costs of expediting might
be chargeable to the customer or absorbed in operating costs. Lost contribution margins are an
opportunity cost and not included in the normal accounting system. Quality costs could be added to
purchase costs in some instances or be part of operating costs.
2. Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision
model
Using an exercise or illustration from the text, show the costs of carrying and ordering
for different order quantities to highlight how EOQ balances those costs.
Using the Self-Study Problem at the end of the chapter, the following could be shown:
As noted in the text problem, the number of deliveries would be eight because deliveries have to be made
in total, not in part. The company would use eight deliveries rather than seven deliveries in consideration
of stockouts.
3. Identify and reduce conflicts that can arise between EOQ decision model and models used for
performance evaluation
Why arent opportunity costs included in the accounting system? One of the key
management accounting guidelines in Chapter 1 was different costs for different purposes. The
characteristics that define and govern financial accounting lead to accounting for what was. Management
accounting includes financial accounting though it extends beyond that particular arena to provide
relevant information for making decisions, both of a financial and a nonfinancial nature. The accounting
system would not include accounting for what might have been. Management accountants would
include such opportunity costs in reports to managers for making decisions in which those costs were
relevant.
Isnt it risky to share so much information with a supplier (in using the supply-chain
approach to inventory management)? A business faces the tension of sharing too much
information, becoming vulnerable to competitors, and of not sharing enough information, driving up costs
and risking the loss of customers. By using the guideline of cost-benefit, managers may make decisions
as to the potential costs in a given situation against the possible benefits in deciding what information to
share and how much. In the situation of inventory management and supply-chain analysis, the benefit of
reducing the level of uncertainty and the level of inventory may outweigh the cost of information that
may be revealed to a competitor about costs and operations.
4. Differentiate materials requirements planning (MRP) systems from just-in-time (JIT) systems
for manufacturing
Can a company adopt a just-in-time system for inventory management and have a
materials requirements planning approach to operations? Does the inventory
management system become a broad management tool also? Materials requirements
planning and just-in-time were originally considered for managing inventory. Because inventory is an
integral part of the manufacturing system, these approaches expanded to company-wide planning and
control activities. Inventory management requires the answers to the key questionshow much
(quantity) and when (timing). MRP is one side of the cointhe need to do good planningand JIT is the
other side of the same cointhe need to do good execution. A company has to understand which system
is most appropriate to their use. Hybrid systems can be developed using aspects of each of the two, MRP
or JIT.
28 Chapter 20
6. Use backflush costing
Discuss the use of the term backflush to describe this costing system.
As noted in Step 5 for assigning costs to units completed (Example 1 illustrating backflush costing in the
chapter), the output trigger point reaches back and pulls the standard costs of direct materials from
Inventory: Raw and In-process and the standard conversion costs for manufacturing the finished goods.
Journal entries would have been made for conversion costs actually incurred. (Dr. Conversion Costs
Control; Cr. Various accounts) The completion point is the first point in the accounting system to
recognize conversion costs as part of the cost of the producta delayed costing. The delay occurs in
recording changes to the status of a product being produced until good finished units appear. When the
good finished units appear, budgeted or standard costs are used to work backward to flush out
manufacturing costs for the units produced. The credit to Conversion Costs Allocated in the entry at
completion reflects the use of budgeted or standard costs. Comparing the Conversion Costs Allocated
account to the Conversion Costs Control account determines the variance.
Entries may have been made when direct materials were purchased if that was a trigger point. If the
purchase of direct materials was not a trigger point, an entry would not have been made for their purchase
(Example 3 with the one trigger point is such a case.). This accounting is appropriate when the lag time
between the receipt of the direct materials and the output of the completed unit is very short. The
accounting for purchases of direct materials is not suspended under backflush, but is abbreviated to reflect
the change in the production process. Similarly, the lack of journalization for work in process is not
omission but recognition that inventories are almost nonexistent.
8. Describe different ways backflush costing can simplify traditional job-costing systems
How can backflush costing account for the conversion of a raw material into a finished
product when only one journal entry is made in the costing system?
Significant changes to the production process, such as adoption of just-in-time, should signal possible
changes to the accounting system that tells the story of that process. Backflush costing developed in
response to streamlined production processes. Companies wanted a simple accounting system rather than
detailed tracking of direct costs through each step of the production process. With changes to the
production process that virtually eliminated inventories, managers did not want to spend resources
tracking costs through the accounts Work in Process, Finished Goods, and Cost of Goods Sold. Also,
backflush costing and sequential tracking produce approximately the same results when inventory is
present, provided inventories maintain stable values. Managers wanted to eliminate nonvalue-added
activities from the cost accounting systems and sequential tracking was nonvalue-added accounting
activity. Generally accepted accounting principles do not require companies track work in process when
the amounts involved are immaterial.
Backflush costing does require that each product have a set of budgeted or standard costs in order to be
used.
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30 Chapter 20