Cost Accounting Inventory Management PDF

Cost Accounting Sixteenth Edition Inventory Management, Just-in- Time, and Simplified Costing Methods SARAH FE SHARON L. GABRIEL,...

Cost Accounting Sixteenth Edition Inventory Management, Just-in- Time, and Simplified Costing Methods SARAH FE SHARON L. GABRIEL, MBA, CMITAP, CPA,LPT Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. Suppose you could receive a large quantity discount for a product that you regularly use, but the discount requires you to buy several month’s supply of it and make a large up-front payment. Would you take the quantity discount? Learning Objectives (1 of 2) 1Identify six categories of costs associated with goods for sale 2Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model 3Identify 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 4Describe why companies Copyright © 2018, are using 2016, 2015 Pearsonjust-in- Education, Inc. All Rights Reserved. Learning Objectives (2 of 2) 5Distinguish materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing 6Identify the features and benefits of a just- in-time productions system 7Describe different ways backflush costing can simplify traditional inventory-costing systems 8Understand the principles of lean accounting Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. Costs Associated with Goods for 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. Costs Associated with Goods for Sale, 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. Costs Associated with Goods for Sale, 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. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 costsCopyright only© to the extent that these 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. Ordering and Carrying Costs, Illustrated Exhibit 20.1 Graphic Analysis of Ordering Costs and Carrying Costs for UX1 Sunglasses at Glare Shade Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 X Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. Ordering Points, Illustrated Exhibit 20.2 Inventory Level of UX1 Sunglasses at Glare Shadea Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2018,face and 2016, 2015 the Pearson need Education, Inc. to hold All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 1. Computeerror: 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 Copyright between © 2018, 2016, 2015 steps Pearson Education, Inc. All1 and Rights Reserved. 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 Copyrightbetween thePearson © 2018, 2016, 2015 EOQEducation, model’s Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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). Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 inventoriesCopyright held by each © 2018, company 2016, 2015 Pearsonin the supply Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. We’ll look next at two of these methods: backflush costing and lean accounting. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 4four 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 byCopyright personal observations, © 2018, 2016, 2015 Pearson Education, computer Inc. All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. 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 Copyright © 2018, 2016, 2015 Pearson Education, Inc. All Rights Reserved. does not correctly account for inventories under 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. Copyright © 2018, 2016, 2015 Pearson Education, Inc. 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