Week 9 Lecture Notes 2

MONASH
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ACW3431
Management Accounting
Week 9
Chapter 20 : Inventory Management, Just-in-Time, and
Simplified Costing Methods
Our learning goals today
1. Identify six categories of costs associated with
goods for sale
2. Balance ordering costs with carrying costs using the
economic-order-quantity (EOQ) decision model
3. Describe why companies are using just-in-time (JIT)
purchasing
4. Distinguish materials requirements planning (MRP)
systems from just-in-time (JIT) systems for
manufacturing
5. Identify the features and benefits of a just-in-time
productions system
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1. Cost associated with goods for sale

Six categories of costs associated with goods for sale
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
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1. Purchasing costs are the cost of goods acquired from
suppliers, including purchase price, incoming freight
costs, sales tax or installation cost. 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.
Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
Details
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 and tracking, Insurance costs on
losses due to theft and obsolescence.
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. e.g restocking costs or loss
customers/sales
Details
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:
a. Prevention
b. Appraisal
c. Internal failure
d. 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.
REVISION QUESTION 1
1. Which of the following categories of costs are important

when managing inventories of goods for sale according to
the authors of the text?
a) Purchasing, ordering, supply, spoilage, and opportunity
b) Purchasing, stockout, carrying, ordering, and quality
c) Buying, holding, invoicing, opportunity, and investment
d) Supply, obsolescence, holding, stockout, and
transportation-in
REVISION QUESTION 2
Among different types of costs associated with

inventory, the incoming freight charges of inventories
are ________.
A) purchasing costs
B) ordering costs
C) stockout costs
D) carrying costs
REVISION QUESTION 3
The costs that result from theft of inventory

are ________.
A) shrinkage costs
B) external failure costs
C) stockout costs
D) costs of quality
REVISION QUESTION 4
Among different types of costs associated with inventory, the
opportunity cost of the investment tied up in inventory is a(n)
________.
A) purchasing cost
B) ordering cost
C) stockout cost
D) carrying cost
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2. Inventory Management
Inventory management
 Inventory management is planning,
coordinating and controlling activities
related to the flow of inventory into, through
and out of an organisation
13
Why hold inventory?
 Cope with uncertainties
 Qualify for quantity discounts
 Avoid future price increases in raw materials
 Avoid the costs of placing numerous small
orders
14
Managing inventory
• Conventional approaches to inventory
management focus on balancing:
– Ordering costs: incremental costs of placing
an order
– Carrying costs: the costs of carrying
inventory in stock
Purchasing managers may wish to order large quantities
to gain the highest possible discounts, but these
discounts will be offset by the high costs of stock-
holding. There is an optimum level, however and stock
managers need to work this out.
15-15
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

• EOQ = 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
Lecture Illustration 1
Consider the following information for Sunny University:
Boxes with
reams of Boxes of Bags of coffee
paper Pens beans
Annual requirements 10 800 1 600 560
Ordering cost $25.00 $40.00 $10.00
Carrying cost per
unit $6.00 $20.00 $7.00
Requirements:
1. Calculate the economic order quantity for each of the above.
2. Calculate total annual costs (ordering+ carrying) for each.
• Total Ordering cost = No of orders X Ordering cost per unit
• Total Carrying cost = (EOQ X carrying cost per unit)/2
• *No of orders= Annual demand/EOQ
1
9
REVISION QUESTION 5
Miniature Company sells stuffed tigers. Birtal Inc. manufactures many different stuffed
animals. Miniature orders 21,200 tigers per year, 22 per week, at $10 per tiger. The
manufacturer covers all shipping costs. Miniature earns 20% on its cash investments. The
purchase-order lead time is 2 weeks. Miniature sells 320 tigers per week. The following data
are available (based on management's estimates):
Estimated ordering costs per purchase order $23

Estimated insurance, materials handling, breakage,
and so on, per year $7
Actual ordering costs per order $27
What is the economic order quantity using the estimated amounts?

A) 698.3 stuffed tigers
Explanation: EOQ =
B) 329.2 stuffed tigers
C) 232.8 stuffed tigers
D) 493.8 stuffed tigers
EOQ = 329.2 units
21
Timing of orders under EOQ
 The key decision in managing inventory is when to re-order a
given product
 Inventory re-order point (ROP) - the quantity level of
inventory on hand that triggers a new purchase order
Annual requirement
No of weeks
22
REVISION QUESTION 6
The following information applies to Krynton Company, which supplies microscopes
to laboratories throughout the country. Krynton purchases the microscopes from a
manufacturer which has a reputation for very high quality in its manufacturing
operation.
Annual demand (weekly demand = 1/52 of annual demand) 53,000 units
Orders per year 20
Lead time in days 18 days
Cost of placing an order $200
What is the reorder point? (Assume a 365 day year.)

A) 1040 units
B) 2614 units Explanation: Reorder point = Number of units sold per time
C) 2650 units period × Purchase-order lead time
Daily demand = 53,000 / (52 × 7) = 145.21
D) 2944 units Therefore, reorder point = 145.21 × 18 = 2614
23
REVISION QUESTION 7
Vision Company sells optical equipment. Blitz Company manufactures special glass
lenses. Vision orders 11,400 lenses per year, 220 per week, at $40 per lens. Blitz covers
all shipping costs. Vision earns 22% on its cash investments. The purchase-order lead
time is 3.0 weeks. Vision sells 315 lenses per week. The following data are available:
Relevant ordering costs per purchase order $47.25

Relevant insurance, materials handling, breakage, and so on, per year $5.50
What is the reorder point?

A) 660 lenses
B) 945.0 lenses
C) 1318 lenses
D) 1605.0 lenses Explanation: Reorder point = Number of units sold per time
period × Purchase-order lead time
Explanation: Reorder point = 315 lenses × 3.0 weeks = 945.0 lenses
24
REVISION QUESTION 8
Globe Inc. is a distributor of DVDs. DVD Mart is a local retail outlet which
sells blank and recorded DVDs. DVD Mart purchases DVDs from Globe at
$29.00 per DVD; DVDs are shipped in packages of 65. Globe pays all
incoming freight, and DVD Mart does not inspect the DVDs due to
Globe's reputation for high quality. Annual demand is 321,000 DVDs at a
rate of 6800 DVDs per week. DVD Mart earns 15% on its cash investments.
The purchase-order lead time is one week. The following cost data are
available:
Relevant ordering costs per purchase order $117.50

Carrying costs per package per year:
Relevant insurance, materials handling,
breakage, etc., per year $9.50
Explanation: EOQ =
What are the annual relevant carrying costs?
A) $9362 EOQ = 63.02 packages
B) $9209
C) $849 Annual relevant carrying costs = = $9209
D) $6511
25
Timing of orders under EOQ
– The level of inventory on hand that
triggers theInventory re-order point
(ROP)
– placement of a new order (or setup)
– Lead time- the length of time between
placing an order and receiving the order
– Can we draw a diagram?
15-26
Delinz Company sells 32 plastic pellets per week. Purchase-
order lead time is 6 weeks and the economic-order quantity
is 480 plastic pellets. What is the reorder point?
A) 192 plastic pellets
B) 2880 plastic pellets
Explanation: Reorder point = 32 ×6
C) 1260 plastic pellets
= 192 units
D) 210 plastic pellets
Ordering, lead time and usage of plastic pellets inventory
28
Inventory management and safety stock
 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
=192 +20
=212 bags
 Safety stock may be costly to maintain
29
30
Sunny University operates on a 50 week per year basis (it closes down
for two weeks at the end of each year). Annual demand 10,800
Historically, the length of time between placing an order for boxes of
paper and receiving it is one and a half weeks. Also, the demand for
paper shows some fluctuation depending on the time of the year. It
varies between 160 and 300 boxes.
Requirements:
1. Assuming the demand is known and constant (no fluctuation),
calculate the re-order point for boxes of paper.
2. Determine the safety stock for boxes of paper required to avoid
stock-outs.
3. Calculate the re-order point with safety stock for boxes of paper.
31
Lecture Illustration 3- answer

1. ROP = Avg demand x lead time
= Note : Avg demand = Number of

= 216 x 1.5 units sold per time period
= 324 boxes
2. Safety Stock = (Max demand – Avg demand) x lead time
= (300 – ) x 1.5
= 126 boxes
3. ROP = Avg demand x lead time + Safety stock
= 324 + 126
= 450 boxes
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3. Managing inventory- Just in Time

(JIT) Approach and MRP
Just-in-time (JIT) systems
• A pull method of coordinating production
processes
– As opposed to a push system
• The underlying philosophy is the simplifying

of the production process by removing non-
value-added activities
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Examples of Successful JIT systems
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REVISION QUESTION 9
Which ones of the above are value adding and which
ones are not?
• Process time Value adding
• Inspection time N. Value adding
• Move time N. Value adding
• Queue time N. Value adding
• Storage time N. Value adding
Non-value added activities are activities that do not add value from customers
perspective
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Push vs Pull systems
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Inventory Management AND MRP
• 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.
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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.
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Just-in-time (JIT) systems
• JIT can cover all aspects of the production process
– Inventory management is crucial
– Inventory is a major cause of non-value-added
activities and cost
• Goals:
– Timely meeting of customer demands
– High quality products
– Lowest possible cost
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Key features of JIT system
• High-quality levels for raw materials,
components and finished products
• Effective preventative maintenance of

equipment
Requires TQM !!
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JIT STRATEGIES
JIT JIT
PURCHASING PRODUCTION
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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.
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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) or (EPOS).
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REVISION QUESTION 10
Which of the following statements is true of just-in-time (JIT)
purchasing?
A. In JIT purchasing, the optimal safety-stock level is the quantity of

safety stock that minimizes the sum of annual relevant stockout
and carrying costs.
B. JIT purchasing is guided solely by the EOQ model because that
model emphasizes the tradeoff between relevant carrying and
ordering costs.
C. In JIT purchasing, raw materials (or goods) are purchased so that
products are delivered just as needed for production or sales.
D. D) Only disadvantage of JIT purchasing is the higher level
carrying and inspection costs.
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JIT Production
• 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.
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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.
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Costs and Benefits of JIT Production
Advantages of JIT
1. reductions in the cost of holding stock
2. space that was used for storing stock can be released for other
activities
3. minimal inventory releases cash flow for use elsewhere in the
business
4. reduces the chance of holding obsolescent stock with less
chance of damaged stock
5. allows a firm to lower its break-even point
6. improved motivation and teamwork with more flexible and
multi-skilled employees
7. promotes customer focus and increased flexibility and
responsiveness to individual customer needs
8. allows for greater customisation in the production process
9. greater focus on quality and zero defects and lowering of waste
levels
10.strengthens collaboration along the supply chain
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Disadvantages of JIT
1. there is a heavy reliance on suppliers - any failures in delivery can lead

to expensive production delays and stock-outs
2. JIT does not cope well with sudden surges in demand
3. lower stock order quantities does not allow for the same level of
purchasing economies of scale as found in traditional stock control
systems
4. frequent small deliveries are likely to be expensive as there will be
fewer bulk discounts
5. administration costs are likely to be higher maintaining stock levels and
ensuring no stock-outs
6. JIT requires a change in management style - not all managers and
workers are prepared to 'buy-in to the philosophy'
7. training costs can be higher than traditional production systems
8. JIT needs expensive computer technologies and robotics for its smooth
operation
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Which of the following statements best defines a just-in-time
production system?
A. a push-through system that manufactures finished goods
for inventory on the basis of demand forecasts
B. a push-through system in which each component in a
production line is produced immediately as needed by the
next step in the production line
C. a demand-pull system that manufactures finished goods
for inventory on the basis of demand forecasts
D. a demand-pull system in which each component in a
production line is produced immediately as needed by the
next step in the production line
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A demand-pull system in which each component in a
production line is produced immediately as needed
by the next step in the production line is referred to
as ________.
A) just-in-time production
B) materials requirements planning
C) relevant total costs
D) economic order quantity
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The Controller of Nip-it-in-the-Bud Inc. has studied the
possibility of implementing a JIT production system. The annual
incremental retooling costs of the JIT system is projected to be
about $67,000 however, the new system will lower insurance
costs by $10,000 and storage costs will drop by $20,000 a year as
the company will be able to reuse warehouse space for other
strategic purposes. In addition, material handling costs will drop
by $10,000 a year and because of a resulting increase in quality
and faster delivery, the company's contribution margin on the
product will increase by $2.00 on annual sales of 20,000 units.
Required:
Calculate the net incremental benefit of the JIT system
implementation.
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Answer:
Incremental savings in insurance and storage costs

$30,000
Incremental savings in material handling costs
10,000
Additional contribution margin ($2.00 x 20,000) 40,000
Total incremental operating income
$80,000
Less: Incremental annual retooling costs
(67,000)
Net Incremental benefit
$13,000
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4. Lean Accounting
Lean Accounting
• The resulting improvements in the value chain have led
some JIT companies developed new 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 is a costing method that focuses on

value streams, as distinguished from individual products
or departments, thereby eliminating waste in the
accounting process.
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Value Streams
• 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.
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Lean Accounting and Value Streams
Lean accounting is much simpler than traditional product
costing because calculating actual product costs by value
streams requires less overhead allocation. 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, it does not correctly account
for inventories under GAAP.
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A system that emphasizes lean production
techniques, low quantities of inventory, and close
coordination among production workstations is
called ________.
A) Economic order quantity production
B) Just-in-time production
C) Materials requirements planning production
D) Push-through system
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1) Which of the following statements is true of lean
accounting?
A. It is much complex than traditional product costing but
produces more accurate product unit costs.
B. It does not always compute costs for individual products
but does emphasize product costs by value stream.
C. It omits recording some of the journal entries relating to
the stages from the purchase of direct materials to the
sale of finished goods.
D. It is acceptable under GAAP.
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THANK YOU
Phew! It’s Finally Over

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MONASH

1. Cost associated with goods for sale

2. Ordering costs are the costs of preparing and issuing

4. Stockout costs are the costs that arise when a company

6. Shrinkage costs are costs that result from theft by outsiders,

1. Which of the following categories of costs are important

Among different types of costs associated with

The costs that result from theft of inventory

The economic order quantity (EOQ) is a

Let’s look at some of the basic EOQ assumptions.

• D = Demand in units for specified period

Estimated ordering costs per purchase order $23

What is the economic order quantity using the estimated amounts?

What is the reorder point? (Assume a 365 day year.)

Relevant ordering costs per purchase order $47.25

What is the reorder point?

Relevant ordering costs per purchase order $117.50

Lecture Illustration 3- answer

= Note : Avg demand = Number of

2. Safety Stock = (Max demand – Avg demand) x lead time

3. ROP = Avg demand x lead time + Safety stock

3. Managing inventory- Just in Time

• The underlying philosophy is the simplifying

• Inspection time N. Value adding

• Move time N. Value adding

• Queue time N. Value adding

• Storage time N. Value adding

• JIT production is a “demand-pull” approach and is also

• Effective preventative maintenance of

• Just-in-time (JIT) purchasing is the purchase of materials

• JIT purchasing is not guided solely by the EOQ model

– Companies are using electronic links to place

A. In JIT purchasing, the optimal safety-stock level is the quantity of

• Demand triggers each step of the production process,

1. there is a heavy reliance on suppliers - any failures in delivery can lead

Incremental savings in insurance and storage costs

• Lean accounting is a costing method that focuses on

• Value streams are all the value-added activities needed

• Tracing more costs as direct costs to value streams is

Phew! It’s Finally Over

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