Cost Accounting: Sixteenth Edition, Global Edition

Cost Accounting
Sixteenth Edition, Global Edition
Chapter 20
Inventory Management,
Just-in-Time, and
Simplified Costing
Methods
Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Learning Objectives (1 of 2)
20.1 Identify six categories of costs associated with goods
for sale
20.2 Balance ordering costs with carrying costs using the
economic-order-quantity (EOQ) decision model
20.3 Identify the effect of errors that can arise when using
the EOQ decision model and ways to reduce conflicts
between the EOQ model and models used for performance
evaluation
20.4 Describe why companies are using just-in-time (JIT)
purchasing
Learning Objectives (2 of 2)
20.5 Distinguish materials requirements planning (MRP)
systems from just-in-time (JIT) systems for manufacturing
20.6 Identify the features and benefits of a just-in-time
productions system
20.7 Describe different ways backflush costing can simplify
traditional inventory-costing systems
20.8 Understand the principles of lean accounting
Inventory Management in Retail
Organizations
Inventory management includes planning, coordinating, and
controlling activities related to the flow of inventory into,
through, and out of an organization.
There are a number of different types of costs associated
with inventory other than the cost of the actual goods
purchased.
Costs Associated with Goods for Sale,
Overview
• Managing inventories to increase net income requires
effectively managing costs that fall into these six
categories:
1. Purchasing costs
2. Ordering costs
3. Carrying costs
4. Stockout costs
5. Quality costs
6. Shrinkage costs
Details (1 of 3)
1. Purchasing costs are the cost of goods acquired from
suppliers, including incoming freight costs. Usually this
is the largest cost category of goods in inventory.
2. Ordering costs are the costs of preparing and issuing
purchase orders, receiving and inspecting the items
included in the orders, and matching invoices received,
purchase orders, and delivery records to make
payments.
Details (2 of 3)
3. Carrying costs are the costs that arise while goods are
being held in inventory. These costs include the
opportunity cost of the investment tied up in inventory,
and costs associated with storage.
4. Stockout costs are the costs that arise when a company
runs out of a particular item for which there is customer
demand (stockout). The company must act quickly to
replenish inventory to meet that demand or suffer the
costs of not meeting it.
Details (3 of 3)
5. Costs of Quality are the costs incurred to prevent and
appraise, or the costs arising as a result of, quality issues.
Recall from Chapter 19, there are four categories of quality
costs:
1. Prevention
2. Appraisal
3. Internal failure
4. External failure
6. Shrinkage costs are costs that result from theft by outsiders,
embezzlement by employees and misclassifications or
misplacement of inventory. Shrinkage is measured by the
difference between the cost of inventory recorded on the
books versus the cost of inventory when physically counted.
The Economic-Order-Quantity Decision
Model
How much should a firm order of a given product?
The economic order quantity (EOQ) is a decision model,
that, under a given set of assumptions, calculates the
optimal quantity of inventory to order.
Let’s look at some of the basic EOQ assumptions.
Basic EOQ Assumptions
• The simplest version of the EOQ model assumes there
are only ordering and carrying costs.
• The same quantity is ordered at each reorder point.
• Demand, ordering costs, and carrying costs are known
with certainty, as is the purchase order lead time (the time
between placing an order and its delivery).
• Purchasing costs per unit are unaffected by the quantity
ordered. (Therefore, purchasing costs are irrelevant.)
• No stockouts occur.
• Managers consider the costs of quality and shrinkage
costs only to the extent that these costs affect ordering or
carrying costs.
EOQ Formula—Results in the Quantity
that Minimizes Annual Relevant Total
Costs
• D = Demand in units for specified period
• Q = Size of each order (order quantity)
• P = Relevant ordering costs per purchase order
• C = Relevant carrying costs of one unit in stock for the time period used for D
Ordering and Carrying Costs, Illustrated
Exhibit 20.1 Graphic Analysis of Ordering Costs and Carrying Costs for UX1 Sunglasses at
Glare Shade
When to Order (Assumes Certainty of
Demand and Lead Time)
• The second decision in managing goods for sale is when
to order a given product.
• The reorder point is the quantity level of inventory on hand
that triggers a new purchase order.
• The reorder point is simplest to compute when both
demand and the purchase-order lead time are known with
certainty.
Reorder Number of units sold Purchase Order

Point = per unit of time X Lead Time
Ordering Points, Illustrated
Exhibit 20.2 Inventory Level of UX1 Sunglasses at Glare Shadea
Safety Stock (Demand and Lead Time
Uncertain)
• Safety stock is inventory held at all times regardless of the
quantity of inventory ordered using the EOQ model.
– Safety stock is a buffer against unexpected increases in
demand, uncertainty about lead time, and unavailability of
stock from suppliers.
– Managers use a frequency distribution based on prior daily
or weekly levels of demand to compute safety-stock levels.
Companies are getting increasingly sophisticated at
understanding customers using techniques such as design
thinking and data analytics. This deeper understanding
reduces the uncertainties about demand that companies face
and the need to hold large quantities of safety stock.
Estimating Inventory-Related Relevant
Costs and their Effects
The relevant costs are categorized as follows:
• Carrying costs—see next slide for more details
• Stockout costs—the cost of expediting an order from a
supplier
• Ordering costs—those ordering costs that change with the
number of orders placed
Carrying Costs
• Relevant inventory carrying costs consist of relevant
incremental costs and the relevant opportunity cost of
capital.
• Relevant incremental costs—those costs of the purchasing
firm that change with the quantity of inventory held.
Relevant Opportunity Costs of Capital
• Relevant opportunity cost of capital—the return foregone
by investing capital in inventory rather than elsewhere.
• It is calculated as the required rate of return multiplied by
the per-unit costs of acquiring inventory, such as the
purchase price of units, incoming freight, and incoming
inspection.
• Opportunity costs are also computed on investments if
these investments are affected by changes in inventory
levels.
Cost of a Prediction Error
Predicting relevant costs is difficult and seldom flawless,
which raises the question, “What is the cost when actual
relevant costs differ from the estimated relevant costs used
for decision making?”
• Three steps in determining the cost of a prediction error:
1. Compute the monetary outcome from the best action
that could be taken, given the actual amount of the
cost input (cost per purchase order).
2. Compute the monetary outcome from the best action
based on the incorrect predicted amount of the cost
input (cost per purchase order).
3. Compute the difference between steps 1 and 2.
Conflicts Between the EOQ Decision
Model and Managers’ Performance
Evaluation
What happens if the order quantity based on the EOQ decision
model differs from the order quantity managers would choose to
make their own performance look best?
As an example, we have learned that the EOQ model takes into
account opportunity costs because these costs are relevant costs
when calculating inventory carrying costs. However, managers
evaluated on financial accounting numbers, which is often the
case, will ignore opportunity costs.
Managers interested in making their own performance look better
will only focus on measures used to evaluate their performance.
Conflicts will then arise between the EOQ model’s optimal order
quantity and the order quantity that managers regard as optimal.
Just-in-Time Purchasing (1 of 2)
• Just-in-time (JIT) purchasing is the purchase of materials
or goods so that they are delivered just as needed for
production or sales.
• JIT purchasing is not guided solely by the EOQ model
because that model only emphasizes the tradeoff between
relevant carrying and ordering costs.
Just-in-Time Purchasing (2 of 2)
• JIT reduces the cost of placing a purchase order because:
– Long-term purchasing agreements define price and
quality terms. Individual purchase orders covered by
those agreements require no additional negotiation
regarding price or quality.
– Companies are using electronic links to place purchase
orders at a small fraction of traditional methods (phone
or mail).
– Companies are using purchase-order cards (similar to
consumer credit cards).
Relevant Costs in JIT Purchasing
Relevant costs for the EOQ model are the carrying and ordering costs.
Inventory management includes purchasing costs, stockout costs,
costs of quality, and shrinkage costs.
JIT relevant costs include:
• Purchasing costs
• Ordering costs
• Opportunity costs
• Carrying costs
• Stockout costs
• Quality costs
JIT Purchasing, Planning and Control,
and Supply-Chain Analysis
• Supply chain describes the flow of goods, services, and information from
the initial sources of materials and services to the delivery of products to
consumers, regardless of whether those activities occur in the same
company or other companies.
• Supply chain members share information and plan/coordinate activities.
Sharing sales information reduces the level of uncertainty about retail
demand and leads to:
• 1) fewer stockouts at the retail level,
• 2) reduced manufacturing of product not immediately needed by retailers,
• 3) fewer manufacturing orders that have to be “rushed” or “expedited,”
and
• 4) lower inventories held by each company in the supply chain.
Inventory Management, MRP, and JIP
Production
• Materials requirements planning (MRP) is a “push-through”
system that manufactures finished goods for inventory on
the basis of demand forecasts.
• JIT production is a “demand-pull” approach and is also
called lean production. Each component in a production
line is produced as soon as, and only when, needed by the
next step in the production line.
MRP Information Inputs
• To determine outputs at each stage of production, MRP
uses:
1. The demand forecasts for final products.
2. A bill of materials detailing the materials, components,
and subassemblies for each final product.
3. Information about a company’s inventories of
materials, components, and products.
MRP, Process
• Taking into account the lead time required to purchase
materials and to manufacture components and finished
products, a master production schedule specifies the
quantity and timing of each item to be produced.
• Once production starts as scheduled, the output of each
department is pushed through the production line.
• Maintaining accurate inventory records and costs is critical
in an MRP system.
JIT Production (1 of 2)
• JIT (lean) production is a “demand-pull” manufacturing
system that manufactures each component in a production
line as soon as, and only when, needed by the next step in
the production line.
• Demand triggers each step of the production process,
starting with customer demand for a finished product at the
end of the process and working all the way back to the
demand for direct materials at the beginning of the
process.
JIT Production (2 of 2)
As customer information systems get increasingly
sophisticated and computing power allows companies to
process and analyze large quantities of data, companies are
able to develop deep insights into the needs of customers.
As a result, many companies are combining the best
features of MRP and JIT systems—anticipating demand
changes to some extent but continuing to operate flexible
production systems to quickly respond to fluctuations in
demand.
Features of JIT Production Systems
• Production is organized in manufacturing cells, which are
work areas with different types of equipment grouped
together to make related products.
• Workers are hired and trained to be multi-skilled (cross-
trained).
• Defects are aggressively eliminated.
• Setup time and manufacturing cycle time are reduced.
• Suppliers are selected on the basis of their ability to deliver
quality materials in a timely manner.
Costs and Benefits of JIT Production
• Lower inventory levels, lower carrying costs
• Heightened emphasis on improving quality by eliminating
the specific causes of rework, scrap, and waste
• Lower manufacturing cycle times
Enterprise Resource Planning (ERP)
Systems (1 of 2)
ERP systems are frequently used in conjunction with JIT
production.
• An ERP system is an integrated set of software modules
covering a company’s accounting, distribution, manufacturing,
purchasing, human resources and other functions.
• Real-time information is collected in a single database and
simultaneously fed into all of the software applications, giving
personnel greater visibility into the company’s end-to-end
business processes.
• Companies believe that an ERP system is essential to support
JIT initiatives because of the effect it has on lead time.
Enterprise Resource Planning (ERP)
Systems (2 of 2)
The challenge, when implementing ERP systems, is to strike
the proper balance between the lower cost and reliability of
standardized systems and the strategic benefits that accrue
from customization.
Performance Measures and Control in
JIT
In addition to their personal observations, managers use financial
and nonfinancial measures to evaluate and control JIT production.
• Financial performance measures such as inventory turnover ratio,
which is expected to increase.
• Nonfinancial performance measures inventory, quality and time
such as the following:
 Number of days of inventory on hand, expected to decrease.
 Units produced per hour, expected to increase
 Number of units scrapped or requiring rework/Total number of units started
and completed, expected to increase
 Manufacturing cycle time: expected to decrease.
 Total setup time for machines/Total manufacturing time, expected to
decrease.
EFFECT OF JIT SYSTEMS ON
PRODUCT COSTING
By reducing materials handling, warehousing and inspection,
JIT systems reduce overhead costs.
JIT systems also aid in the direct tracing of some costs
usually classified as indirect.
These changes have prompted some companies using JIT to
adopt simplified product-costing methods that dovetail with JIT
production and that are less costly to operate than the
traditional costing systems described in Chapters 4, 7, 8, and
17.
We’ll look next at two of these methods: backflush costing
and lean accounting.
BACKFLUSH COSTING (1 of 3)
Traditional normal or standard-costing systems use
sequential tracking in which the recording of the journal
entries occurs in the same order as actual purchases and
progress in production.
As a reminder, the four stages are:
Purchase of Direct Materials & Incurring of Conversion
costs*
Production resulting in WIP
Completion of good finished units of product*
Sales of finished goods*
* Indicates a trigger point for journal entries
Backflush Costing (2 of 3)
A trigger point is a stage in the cycle, from the purchase of
direct materials and incurring of conversion costs (Stage A)
to the sale of finished goods (Stage D), at which journal
entries are made in the accounting system.
• Backflush costing omits recording some of the journal
entries relating to the stages from the purchase of direct
materials to the sale of finished goods.
– Because some stages 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.
When inventories are minimal, as in JIT production systems,
backflush costing simplifies costing systems without losing
much information.
BACKFLUSH COSTING (3 of 3)
• 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.
• The absence of sizable amounts of materials inventory,
work-in-process inventory, and finished-goods inventory
means managers can keep track of operations by personal
observations, computer monitoring, and nonfinancial
measures.
Lean Accounting
• Another simplified product costing system that can be used
with JIT (or lean production) systems is lean accounting.
• When a company utilizes JIT production, it has to focus on
the entire value chain of business functions (from suppliers
to manufacturers to customer) in order to reduce
inventories, lead times and waste.
• The resulting improvements in the value chain have led
some JIT companies to develop organizational structures
and costing systems that focus on value streams —all
value-added activities needed to design, manufacture, and
deliver a given product or product line to customers.
Lean Accounting and Value Streams (1 of
3)
• Lean accounting is a costing method that focuses on value

streams, as distinguished from individual products or
departments, thereby eliminating waste in the accounting
process.
• Value streams are all the value-added activities needed to
design, manufacture, and deliver a given product or
product line to customers.
• Tracing more costs as direct costs to value streams is
possible because companies using lean accounting often
dedicate resources to individual value streams.
Lean Accounting and Value Streams (2 of
3)
• Lean accounting is much simpler than traditional product

costing because calculating actual product costs by value
streams requires less overhead allocation. Here are some
criticisms of lean accounting.
1. Critics of lean accounting charge that it does not compute
the costs of individual products, which makes it less useful
for making decisions.
2. Critics of lean accounting charge that it excludes certain
support costs and unused capacity costs.
3. A final criticism is that, like backflush costing, it does not
correctly account for inventories under GAAP.
Lean Accounting And Value Streams (3 of
3)
Here are what proponents of lean accounting say about the three criticisms:
• Individual product costs—Proponents of lean accounting argue that the
lack of individual product costs is not a problem because most decisions
are made at the product line level rather than the individual product level
and that pricing decisions are based on the value created and not product
costs.
• Exclusion of certain costs—Proponents also argue that the method
overcomes this problem by adding a larger markup on value-stream costs
because customers will be unwilling to pay for non-value-added costs.
• Non-compliance with GAAP—Here, proponents are quick to point out that
in lean accounting environments, work-in-process and finished-goods
inventories are immaterial from an accounting perspective.
Terms to Learn—(1 of 2)
TERMS TO LEARN PAGE NUMBER
REFERENCE
Backflush costing 816
Carrying costs 799
Economic order quantity (EOQ) 800
Enterprise resource planning (ERP) system 814
Inventory management 799
Just-in-time (JIT) production 812
Just-in-time (JIT) purchasing 807
Lean accounting 825
Lean production 812
Manufacturing cells 812
Materials requirements planning (MRP) system 812
Ordering costs 799
Terms to Learn—(2 of 2)
TERMS TO LEARN PAGE NUMBER
REFERENCE
Purchase-order lead time 800
Purchasing costs 799
Reorder point 802
Safety stock 803
Sequential tracking 816
Shrinkage costs 800
Stockout costs 799
Trigger point 816
Value streams 824
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Cost Accounting

Sixteenth Edition, Global Edition

• D = Demand in units for specified period

• Q = Size of each order (order quantity)

• P = Relevant ordering costs per purchase order

Reorder Number of units sold Purchase Order

• Lean accounting is a costing method that focuses on value

• Lean accounting is much simpler than traditional product

Ordering costs 799

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