University:
California State University, Northridge
Course:
ACCT 230 | Introduction to Managerial Accounting
Academic year:

2024
Views:

143

Pages:

21
Author:

Rebecca Edwards

Chapter 8: Absorption and Variable Costing, and Inventory Management Part 2 3 Decision Making for Inventory Management ►Inventory can definitely affect operating income. ►In addition to the product cost of inventory, there are other types of costs that relate to inventories of raw materials, work in process, and finished goods. 3 Inventory-Related Costs ► If the inventory is a material or good purchased from an outside source, then these inventory-related costs are known as ordering costs and carrying costs. ► If the material or good is produced internally, then the costs are called setup costs and carrying costs. ► Ordering costs are the costs of placing and receiving an order. ► Carrying costs are the costs of keeping and storing inventory. ► Stockout costs are the costs of not having a product available when demanded by a customer or the cost of not having a raw material available when needed for production. 3 Traditional Reasons for Carrying Inventory Economic Order Quantity: The Traditional Model 3 ► Once a company decides to carry inventory, two basic questions must be addressed: 1. 2. How much should be ordered? When should the order be placed? ► In choosing an order quantity, managers need to be concerned only with ordering and carrying costs. ► The formulas for calculating these are as follows: 3 Cornerstone 8-6 Calculating Ordering Cost, Carrying Cost, and Total Inventory-Related Cost 3 Average Inventory ►The average amount in inventory is the maximum plus the minimum divided by two. Average Inventory = (Maximum amount + Minimum amount) 2 3 The Economic Order Quantity ►Maintaining an order quantity equal to the average inventory may not be the best choice. Some other order quantity may produce a lower total cost. ►The objective is to find the order quantity that minimizes the total cost. ►The number of units in the optimal size order quantity is called the economic order quantity (EOQ). 3 The Economic Order Quantity (continued) ►Since EOQ is the quantity that minimizes total inventory-related costs, a formula for computing it is: 3 Cornerstone 8-7 Calculating Economic Order Quantity (EOQ) 3 Cornerstone 8-7 Calculating Economic Order Quantity (EOQ) (continued) 3 Reorder Point ► Knowing when to place an order (or setup for production) is also an essential part of any inventory policy. ► The reorder point is the point in time when a new order should be placed (or setup started). ► It is a function of the EOQ, the lead time, and the rate at which inventory is used. Lead time is the time required to receive the economic order quantity once an order is placed or a setup is started. ► Knowing the rate of usage and lead time allows us to compute the reorder point that accomplishes these objectives: Reorder point = Rate of usage x Lead time 3 Cornerstone 8-8 Calculating The Reorder Point When Usage Is Known with Certainty 3 Safety Stock ►Safety stock is extra inventory carried to serve as insurance against changes in demand. ►Safety stock is computed by multiplying the lead time by the difference between the maximum rate of usage and the average rate of usage: Safety stock = Maximum Average x Lead time daily usage daily usage 3 Cornerstone 8-9 Calculating Safety Stock and the Reorder Point with Safety Stock 3 Economic Order Quantity and Inventory Management ► The EOQ model is very useful in identifying the optimal trade-off between inventory ordering costs and carrying costs. ►It also is useful in helping to deal with uncertainty by using safety stock. ► The historical importance of the EOQ model in many American industries can be better appreciated by understanding the nature of the traditional manufacturing environment. ►This environment has been characterized by the mass production of a few standardized products that typically have a very high setup cost. ► The high setup cost encouraged a large batch size. ►Thus, production runs for these firms tended to be quite long, and the excess production was placed in inventory. 3 Just-in-Time Approach to Inventory Management ►The just-in-time (JIT) approach maintains that goods should be pulled through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand. ►The material or subassembly arrives just in time for production to occur so that demand can be met. ►Many fast-food restaurants, like McDonald’s, use this type of pull system to control their finished goods inventory. 3 Comparing Just-in-Time and Traditional Inventory Approaches: Ordering Costs ►In a traditional system, inventory resolves the conflict between ordering or setup costs and carrying costs by selecting an inventory level that minimizes the sum of these costs. ►In a JIT environment, however, ordering costs are reduced by developing close relationships with suppliers. 3 Comparing JIT and Traditional Inventory Approaches: Uncertainty in Demand ►According to the traditional view, inventories prevent shutdowns caused by machine failure, defective material or subassembly, and unavailability of a raw material or subassembly. ►JIT solves these three problems by emphasizing total preventive maintenance and total quality control and by building the right kind of relationship with suppliers. 3 Comparing JIT and Traditional Inventory Approaches: Lower Cost of Inventory ►Traditionally, inventories are carried so that a firm can take advantage of quantity discounts and hedge against future price increases of the items purchased. ►The objective is to lower the cost of inventory. ►JIT achieves the same objective without carrying inventories, through long-term contracts with a few chosen suppliers located as close to the production facility as possible to establish more extensive supplier involvement. 3 Limitations of Just-in-Time Approach ► JIT does have limitations. ► It is often referred to as a program of simplification—yet this does not imply that JIT is simple or easy to implement. ► It requires time for building sound relationships with suppliers. ► Insisting on immediate changes in delivery times and quality may not be realistic and may cause difficult confrontations between a company and its suppliers. ► Reductions in inventory buffers may cause a regimented workflow and high levels of stress among production workers. ► It requires careful and thorough planning and preparation.