20

Inventory Management:
Economic Order Quantity,
JIT, and the Theory of
Constraints
20-1
Economic Order Quantity Management 1

• To develop an inventory policy that deals with the

tradeoff between acquisition costs and carrying costs,
two basic questions must be addressed:
• How much should be ordered (or produced) to
minimize inventory costs?
• When should the order be placed (or the setup
done)?

20-2
Economic Order Quantity Management 1

Total ordering and carrying cost can be

described as:

TC  PD / Q  CQ / 2
Where:
TC = the total ordering and carrying cost
P = the cost of placing and receiving an order
Q=the number of units ordered each time an
order is placed
D = the known annual demand
C = the cost of carrying one unit of stock for one
year 20-3
Economic Order Quantity Management 1

The objective of inventory management is to

identify the order quantity that minimizes the total
cost – called the Economic Order Quantity

EOQ  2 DO / C

20-4
Economic Order Quantity Management 1

When to Order or Produce

Reorder point: the point in time when a new order should be

placed
Lead time: the time required to receive the economic order
quantity once an order is place or a setup is initiated

Reorder point: Rate of usage * Lead time

Because the demand for a product is not known with certainty, the
possibility of a stock-out exits. Safety stock can help avoid this.
Safety stock: extra inventory carried to serve as insurance against
fluctuations in demand

Reorder point: (Average rate of usage * Lead time) +

Safety stock
20-5
 Normal time usage = Normal Lead Time x Average Usage

 Safety Stock
= (Maximum Lead Time- Normal Lead Time) x Average Usage

Total Order Cost = (Annual Demand/ EOQ) x Order Cost

Total Carrying Cost = (EOQ/2) x Carrying Cost

1-6
 Emil Traders, Inc. sells cellphone cases
which it buys from a local manufacturer. Emil
Traders sells 24,000 cases evenly throughout
the year. The cost of carrying one unit in
inventory for one year is P11.52 and the
order cost per order is P38.40.
 Compute the EOQ
 Total Order Cost
 Total inventory carrying cost

1-7
 The following information is available for Edgar
corporation’s Material X
 Annual usage 12,600
 Working Days 360
 Normal lead time 20
The units of material x are required evenly
throughout the year.
1. Re-order point
Assuming that occasionally, the company
experiences delay in the delivery of Material X, such
that the lead time reaches a maximum of 30 days,
how many units of safety stock should the company
maintain and what is the reorder point.
1. Safety Stock
2. Re-order point
1-8
 Using the EOQ model, Apple Baby
Corporation computed the economic order
quantity for one of the products it sells to be
4,000 units. Apple Baby Corporation
maintains safety stock of 300 units. The
quarterly demand for the product is 10,000
units. The order cost is P200 per order. The
purchase price of the product is P2.40. The
company sells at a 100% markup. The annual
inventory carrying cost is equal to 25% of the
average inventory level.
 Total inventory Ordering Cost?

1-9
JIT Inventory Management 2

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.

20-10
JIT Inventory Management 2

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

20-11
JIT Inventory Management 2

Avoidance of Shutdown: The JIT Approach

• Total preventive maintenance to reduce machine failures

• Total quality control to reduce defective parts
• The use of the Kanban system is also essential

20-12
JIT Inventory Management 2

• 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

20-13
JIT Inventory Management 2

JIT Limitations:
1. Patience in implications is needed
2. Time is required
3. JIT may cause lost sales and stressed workers
4. Production may be interrupted due to an absence of
inventory

20-14
Backflush Costing
 An accounting method that records the costs
associated with producing a good or service
only after they are produced, completed or
sold.
 Working backward, calculating the costs of
products after they’re sold, finished or sold.

 Inventory that were required to create the

product.

1-15
 The Pampanga manufacturing company uses a raw
and in process inventory account and expenses all
conversion costs of goods sold account. At the end of
each month, all inventories are counted, their
conversion cost components are estimated, and
inventory account balances are adjusted accordingly.
Raw material cost is backflushed from RIP to Finished
goods. The following information for the month of April:
 Beginning balance of RIP account, including
P1400 of conversion cost……………………. P31,000
 Raw materials received on credit …………… P367,000
 Ending RIP inventory per physical count, including
P1,800 conversion cost estimate……………. P33,000
 Compute the amount to be backflushed from RIP to
finished goods.

1-16
 Katherine, owner of KCO supply company in Cebu,
which manufactures chopsticks for restaurants, has
recently decided to implement a JIT costing system.
Transactions for August are as follows:
 Raw materials were purchased at the cost of
P950,000
 All materials purchased were requisitioned for
production.
 Direct labor costs of P2,500,000 were incurred.
 Actual factory overhead costs amounted to
P6,000,000.
 Applied conversion costs totaled P8,100,000. This
included P2,500,000 of direct labor.
 All units were completed

 RIP to finished goods backflush?

1-17
 Basic Concepts of
Constrained Optimization 3

• Every firm faces limited resources and limited

demand for each product
• External constraints – market demand
• Internal constraints – machine or labor time
availability

Constrained optimization is choosing the optimal

mix given the constraints faced by the firm.

20-18
Theory of Constraints
 methodology for identifying the most
important limiting factor (i.e. constraint) that
stands in the way of achieving a goal and
then systematically improving that constraint
until it is no longer the limiting factor. In
manufacturing, the constraint is often referred
to as a bottleneck.

1-19
1-20
Theory of Constraints (TOC) 4
• Goal – to make money now and in the future by
managing constraints
• Recognizes that the performance of any organization
is limited by its constraints
• TOC focuses on three operational measures of
systems performance
• Throughput = (sales revenue – unit level variable
expenses)/time
• Inventory is all the money the organization spends
in turning materials into throughput
• Operating expenses defined as all the money the
organization spends in turning inventories into
throughput and represent all other money that an
organization spends 20-21
Theory of Constraints (TOC) 4

Five Step Method for Improving 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

20-22
The following information pertains to the four
products of De Boton Corporation. Direct materials
and direct labor are readily available. The
company can acquire as much of these resources
as it requires. However, the company is limited to
a maximum of 1,200 machine hours per month:
P1 P2 P3 P4
Selling price per unit P75 P90 P100 P125
Variable Costs per unit P35 P55 P50 P80
Machine hrs per unit 8 5 25 3

Assuming that there is no market limit for any of the

products, the company should produce and sell?
1-23
Florita Company produces these products with the
following characteristics:
P1 P2 P3
Selling Price P60 P72 P80
Variable Costs per unit P30 P52 P70
CM per unit P30 P20 P10
Units produced per
Machine hrs 1 2 5
Machine hrs available 100,000 hrs
Market Limits- units 0 100,000 200,000

What’s the most profitable product?

The best product mix to maximize profit?
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