Seventeenth Edition, Global Edition: Inventory Management, Just-in-Time, and Simplified Costing Methods

Cost Accounting
Seventeenth Edition, Global Edition
Chapter 21
Inventory Management, Just-in-
Time, and Simplified Costing
Methods
Copyright © 2021 Pearson Education Ltd.

Learning Objectives (1 of 2)
21.1 Identify six categories of costs associated with goods
for sale
21.2 Balance ordering costs with carrying costs using the
economic-order-quantity (EO Q) decision model
21.3 Identify the effect of errors that can arise when using
the E O Q decision model and ways to reduce conflicts
between the E O Q model and models used for
performance evaluation
21.4 Describe why companies are using just-in-time (JI T)
purchasing

Learning Objectives (2 of 2)
21.5 Distinguish materials requirements planning (M R P)

systems from just-in-time (JI T) systems for
manufacturing
21.6 Identify the features and benefits of a just-in-time
productions system
21.7 Describe different ways backflush costing can simplify
traditional inventory-costing systems
21.8 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.
A number of different types of costs are 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

Sale 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.

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.

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 20 the four categories of quality costs:
• Prevention
• Appraisal
• Internal failure
• 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 (EO Q) 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 EO Q assumptions.

Basic E O Q Assumptions
• The simplest version of the EO Q 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.

EO Q Formula—Results in the Quantity That
Minimizes Annual Relevant Total Costs
2DP
EOQ 
C
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 21.1 Graphic Analysis of Ordering Costs and Carrying Costs for U X1
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 Lead Time

Ordering Points Illustrated
Exhibit 21.2 Inventory Level of U X1 Sunglasses at Glare Shade

Safety Stock (Demand and Lead Time
Uncertain)
• Safety stock is inventory held at all times regardless of the
quantity of inventory ordered using the EO Q 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 forgone 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?”
Determining the cost of a prediction error has three steps:
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.

EO Q Decision Model and Managers’
Performance Evaluation
What happens if the order quantity based on the EO Q
decision model differs from the order quantity managers
would choose to make their own performance look best?
For example, we have learned that the EO Q model takes
into account opportunity costs. However, managers
evaluated on financial accounting numbers will ignore
opportunity costs.
Managers interested in making their own performance look
better will only focus on measures used to evaluate their
performance. Conflicts arise between the EO Q model’s
optimal order quantity and the quantity that managers regard
as optimal.

Just-in-Time Purchasing (1 of 2)
• Just-in-time (JI T) purchasing is the purchase of materials
or goods so that they are delivered just as needed for
production or sales.
• JI T purchasing is not guided solely by the EO Q model
because that model only emphasizes the trade-off
between relevant carrying and ordering costs.

Just-in-Time Purchasing (2 of 2)
• JI T reduces the cost of placing a purchase order.
– 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 J I T Purchasing
Relevant costs for the EO Q model are the carrying and
ordering costs.
Inventory management includes purchasing costs, stockout
costs, costs of quality, and shrinkage costs.
JI T relevant costs
• Purchasing costs
• Ordering costs
• Opportunity costs
• Carrying costs
• Stockout costs
• Quality costs

JI T Purchasing, Planning and Control,
and Supply-Chain Analysis (1 of 2)
• 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.

JI T Purchasing, Planning and Control,
and Supply-Chain Analysis (2 of 2)
Sharing sales information reduces the level of uncertainty
about retail demand and leads to the following:
• Fewer stockouts at the retail level
• Reduced manufacturing of product not immediately
needed by retailers
• Fewer manufacturing orders that have to be “rushed” or
“expedited”
• Lower inventories held by each company in the supply
chain

Inventory Management, MR P, and JI T
Production
• Materials requirements planning (MR P) is a “push-

through” system that manufactures finished goods for
inventory on the basis of demand forecasts.
• JI T 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.

MR P Information Inputs
To determine outputs at each stage of production, M R P

uses the following:
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

MR P 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 MR P system.

J I T Production (1 of 2)
• JI T (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.

J I T 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 MR P and JI T systems—anticipating demand
changes to some extent but continuing to operate flexible
production systems to quickly respond to fluctuations in
demand.

Features of J I T 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 multiskilled (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 J I T 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 (ER P)
Systems (1 of 2)
ER P systems are frequently used in conjunction with JI T

production.
• An ER P 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.

Enterprise Resource Planning (ER P)
Systems (2 of 2)
• Companies believe that an ER P system is essential to

support JI T initiatives because of the effect it has on lead
time.
The challenge, when implementing ER P 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 J I T (1 of 2)
In addition to their personal observations, managers use
financial and nonfinancial measures to evaluate and control
JI T production.
• Financial performance measures such as inventory
turnover ratio, which is expected to increase.

Performance Measures and Control
in J I T (2 of 2)
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 J I T Systems on Product
Costing
JI T Systems
• Reduces overhead costs by reducing materials handling,
warehousing, and inspection
• Aids in the direct tracing of some costs usually classified
as indirect
For these reasons, companies using JI T may adopt
simplified product-costing methods that are less costly to
operate than the traditional costing systems described in
Chapters 4, 7, 8, and 18.
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 review, the four stages are as follows:
1. Purchase of Direct Materials & Incurring of Conversion
costs*
2. Production resulting in W I P
3. Completion of good finished units of product*
4. Sales of finished goods*
* Indicates a trigger point for journal entries

• 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 JI T production
systems, backflush costing simplifies costing systems
without losing much information.

• Backflush costing does not comply with GAA P.
– 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 JI T (or lean production) systems is lean accounting.
• When a company utilizes JI T 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 JI T 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 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.
– Critics of lean accounting charge that it does not
compute the costs of individual products, which makes
it less useful for making decisions.
– Critics of lean accounting charge that it excludes
certain support costs and unused capacity costs.
– A final criticism is that, like backflush costing, it does
not correctly account for inventories under GAA P.

• Here are the responses to the criticisms:

– Most decisions are made at the product-line level rather
than the individual product level, and pricing decisions
are based on the value created, not product costs.
– The method adds a larger markup on value-stream
costs because customers will be unwilling to pay for
non-value-added costs.
– The lean accounting environments, work-in-process,
and finished-goods inventories are immaterial from an
accounting perspective.

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Cost Accounting

Seventeenth Edition, Global Edition

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

21.5 Distinguish materials requirements planning (M R P)

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Copyright © 2021 Pearson Education Ltd.

1. Purchasing costs are the cost of goods acquired from

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D = Demand in units for specified period

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Reorder Number of units sold Purchase Order

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The relevant costs are categorized as follows:

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• Supply chain describes the flow of goods, services, and

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• Materials requirements planning (MR P) is a “push-

Copyright © 2021 Pearson Education Ltd.

To determine outputs at each stage of production, M R P

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• Taking into account the lead time required to purchase

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

As customer information systems get increasingly

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• Production is organized in manufacturing cells, which are

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• Lower inventory levels, lower carrying costs

Copyright © 2021 Pearson Education Ltd.

ER P systems are frequently used in conjunction with JI T

Copyright © 2021 Pearson Education Ltd.

• Companies believe that an ER P system is essential to

The challenge, when implementing ER P systems, is to strike

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Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

Copyright © 2021 Pearson Education Ltd.

* Indicates a trigger point for journal entries

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Copyright © 2021 Pearson Education Ltd.

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• Another simplified product costing system that can be used

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• Lean accounting is a costing method that focuses on

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• Lean accounting is much simpler than traditional product