Inventory Management, Just-In-Time, and Backflush Costing

1 Economic-Order-Quantity Decision Model Inventory management includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization. Costs associated with goods for sale: 1. Purchasing costs — the cost of goods acquired from suppliers, including incoming freight costs. Discounts for various purchase-order sizes and supplier credit terms affect purchasing costs. 2. Ordering costs — 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 — the costs that arise while holding an inventory of goods for sale. Carrying costs include the opportunity cost of the investment tied up in inventory and the costs associated with storage, such as space rental, insurance, obsolescence, spoilage, and shrinkage (resulting from theft). 4. Stockout costs — the costs that result when a company runs out of a particular item for which there is customer demand – a stockout – and the company must act quickly to meet that demand or suffer the costs of not meeting it. 5. Quality costs — the costs that result when features and characteristics of a product or service are not in conformance with customer specifications. The economic order quantity (EOQ) is a decision model that, under a given set of assumptions, calculates the optimal quantity of inventory to order. The assumptions are 1. The same quantity (Q) is order at each reorder point. 2. Demand (D), ordering cost (P), and carrying costs (C) are know with certainty. 3. The purchase-order lead time (the time between placing an order and its delivery) is known. 4. Purchasing cost per unit is unaffected by the quantity ordered. 5. No stockputs occur (i.e., the costs of stockouts are so high that managers maintain adequate inventory to prevent them). 6. In deciding on EOQ, managers consider cost of quality only to the extent that these costs ordering or carrying costs. Safety stock is inventory held at all times regardless of the quantity of invenotry ordered using the EOQ model. Safety stock is used as a buffer against unexpected increases in demand, uncertainty about lead time, and unavailablity of stock from suppliers.

2 Just-in-Time Purchasing Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that they are delivered just as needed for production (or sales). Companies moving toward JIT purchasing is to reduce their costs of carrying inventories (parameter C in the EOQ model). At the same time, the cost of placing a purchase order (parameter P in the model) is decreasing because: • Companies are establishing long-term purchasing aggrements that de- fine price and quality terms over an extended period. • Companies are using electronic links, such as the Internet, to place purchase orders at a cost that is estimated to be a small fraction of the cost of placing orders by telephone or by mail. • Companies are using purchase-order cards. 2 As long as purchasing personnel stay within preset total and individual-transaction dollar limits, traditional labor-intensive procurement-approval procedures are not required.

3 MRP and JIT Production Materials requirements planning (MRP) is a “push-through” system that manufactures finished goods for inventory on the basis of demand forecasts. MRP uses: 1. demand forecasts for final products; 2. a bill of materials detailing the materials, components, and subassemblies for each final product; and 3. the quantities of materials, components, and product inventories to determine the necessary outputs at each stage of production. Just-in-time (JIT) production, which is also called lean production, is a “demandpull” manufacturing system that manufactures each component in a production line as soon as, and only when, needed by the next step in the production. JIT production systems aim to simultaneously (1) meet customer demand in a timely way, (2) with high-quality products, and (3) at the lowest possible total cost. A JIT production system has these features: • Production is organized in manufacturing cells, a grouping of all the different types of equipment used to make a given product. • Workers are hired and trained to be multiskilled and capable of performing a variety of operations and tasks, including minor repairs and routine maintenance of equipment. • Defects are aggressively eliminated. Because of the tight links between workstations in the production line and the minimal inventories at each workstation, defects arising at one workstation quickly affect other workstations in the line. JIT creates an urgency for solving problems immediately and eliminating the root causes of defets as quickly as possible. • Setup time is reduced. • Suppliers are selected on the basis of their ability to deliver quality materials in a timely manner. Most companies implementing JIT production also implement JIT purchasing. The success of JIT production system hinges on the speed of information flows from customers to manufacturers to suppliers. The Enterprise Resource Planning (ERP) system comprises a single database that collects data and feeds it into software applications supporting all of a company’s business activities. The performance measures and control in a JIT production: 1. Financial performance measures, such as inventory turnover ratio, 3 which is expected to be imporved. 2. Nonfinancial performance measures of time, inventory and quality, such as: • manufacturing lead time, expected to decrease • units produced per hour, expected to increase • number of days of inventory on hand, expected to decrease • Total setup time for machine Total manufacturing time , expected to decrease • Number of units requiring rework or scarp Total number of units started and completed , expected to decrease

4 Backflush Costing Traditional normal and standard-costing systems use sequential tracking, which is a costing system in which recording of the journal entries occurs in the same order as actual purchases and progress in production.