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

Inventory Management,
Just-in-Time, and
Backflush Costing
Chapter 20
©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 1

Learning Objective 1
Identify five categories of costs

associated with goods for sale.

Costs Associated with
Goods for Sale
1. Purchasing costs include transportation costs.

2. Ordering costs include receiving and
inspecting the items in the orders.
3. Carrying costs include the opportunity cost
of the investment tied up in inventory and
the costs associated with storage.

Costs Associated with
Goods for Sale
4. Stockout costs occur when an organization

runs out of a particular item for which
there is a customer demand.
5. Quality costs of a product or service is its lack
of conformance with a prespecified standard.

Balance ordering costs with

carrying costs using the
economic-order-quantity
(EOQ) decision model.

Economic-Order-Quantity
Decision Model Assumptions
1. The same quantity is ordered at each

reorder point.
2. Demand, ordering costs, carrying costs,
and purchase-order lead time are
known with certainty.
3. Purchasing costs per unit are unaffected
by the quantity ordered.

4. No stockouts occur.
5. Quality costs are considered only to the
extent that these costs affect ordering
costs or carrying costs.

The EOQ minimizes the relevant ordering

costs and carrying costs.
Video store sells packages of blank video tapes.
Video purchases packages of video tapes from
Oaks, Inc., at $15/package.

Annual demand is 12,844 packages, at the

rate of 247 packages per week.
Video requires a 15% annual return on investment.
The purchase-order lead time is two weeks.
What is the economic-order-quantity?

Relevant ordering cost per purchase order: $209

Relevant carrying costs per package per year:
Required annual ROI (15% × $15) $2.25
Relevant other costs 3.25
Total $5.50

Decision Model Example
2DP
EOQ =
C
D = Demand in units for a specified time period

P = Relevant ordering costs per purchase order
C = Relevant carrying costs of one unit in
stock for the time period used for D

2 x12 ,844 x$209

EOQ =
$5.50
976144
, = 988 packages

What are the relevant total costs (RTC)?

RTC = Annual relevant ordering costs
+ Annual relevant carrying costs
D Q DP QC
RTC = Q × P + 2 × C or Q + 2
Q can be any order quantity, not just the EOQ.

When Q = 988 units,

RTC = (12,844 × $209 ÷ 988) + (988 × $5.50 ÷ 2)
= $5,434 total relevant costs
How many deliveries should occur each time period?
D 12,844
EOQ = 988 = 13 deliveries

10,000
Relevant Total Costs (Dollars)
8,000
Annual relevant
total costs
6,000
5,434
4,000 Annual relevant

ordering costs
Annual relevant
carrying costs
2,000
600 988 1,200 1,800 2,400

Order Quantity (Units) EOQ 20 - 15
Reorder Point
Reorder point
= Number of units sold per unit of time
× Purchase-order lead time
EOQ = 988 packages
Number of units sold/week = 247
Purchase-order lead time = 2 weeks
Reorder point = 247 × 2 = 494 packages

Reorder Point
988
Reorder Reorder
Point Point
494
Weeks 1 2 3 4 5 6 7 8
Lead Time Lead Time
2 weeks 2 weeks
This exhibit assumes that demand and purchase-order lead time are certain:
Demand = 247 tape packages/week Purchase-order lead time = 2 weeks
20 - 17
Safety Stock Example
Safety stock is inventory held at all times

regardless of the quantity of inventory
ordered using the EOQ model.
Video’s expected demand is 247 packages per week.
Management feels that a maximum demand of
350 packages per week may occur.

Safety Stock Example
How much safety stock should be carried?

350 Maximum demand – 247 Expected demand
= 103 Excess demand per week
103 packages × 2 weeks lead time
= 206 packages of safety stock.

Considerations in Obtaining
Estimates of Relevant Costs
What are the relevant incremental costs

of carrying inventory?
– only those costs of the purchasing company
that change with the quantity of inventory held

Cost of Prediction Error
Predicting relevant costs requires care

and is difficult.
Assume that Video’s relevant ordering cost
is $97.84 instead of the $209 prediction used.
What is the cost of this prediction error?

Step 1: Compute the monetary outcome

from the best action that could have been
taken, given the actual amount of the cost input.
2 x 12,844x 97.84
EOQ =
$5.50
EOQ = 456 ,966 = 676 packages

The annual relevant total costs when EOQ is

676 packages is:
DP QC
RTC = +
Q 2
RTC = (12,844 × $97.84 ÷ 676) + (676 × $5.50 ÷ 2)

= $3,718 total relevant costs
Step 2: Compute the monetary outcome

from the best action based on the incorrect
amount of the predicted cost input.
2 x12 ,844 x$209

EOQ = = 988 packages
$5.50

What are the annual relevant costs using

this order quantity when
D = 12,844 units, P = $97.84, and C = $5.50?
RTC = (12,844 × $97.84 ÷ 988) + (988 × $5.50 ÷ 2)
= $ 3,989 total relevant costs

Step 3: Compute the difference between

the monetary outcomes from Steps 1 & 2.
Step 1 $3,718
Step 2 3,989
Difference $ (271)
The cost of prediction error is $271.

Identify and reduce conflicts

that can arise between EOQ
decision model and models used
for performance evaluation.

Evaluating Managers and
Goal-Congruence Issues
The opportunity cost of investment tied up

in inventory is a key input in the
EOQ decision model.
Some companies now include opportunity
costs as well as actual costs when
evaluating managers.

Just-In-Time Purchasing
Just-in-time (JIT) purchasing is the purchase

of goods or materials such that a delivery
immediately precedes demand or use.
Companies moving toward JIT purchasing
argue that the cost of carrying inventories
(parameter C in the EOQ model) has been
dramatically underestimated in the past.
JIT Purchasing and EOQ
Model Parameters
The cost of placing a purchase order

(parameter P in the EOQ model) is
also being re-evaluated.
Three factors are causing sizable reduction
in the cost of placing a purchase order (P).
1. Companies increasingly are establishing
long-run purchasing arrangements.
JIT Purchasing and EOQ
Model Parameters
2. Companies are using electronic links,

such as the Internet, to place purchase orders.
3. Companies are increasing the use of
purchase order cards (similar to consumer
credit cards like Visa and Master Card).

Use a supply-chain approach

to inventory management.

Supply-Chain Analysis
Supply-chain analysis describes the flow

of goods, services, and information from
cradle to grave, regardless of whether
those activities occur in the same
organization or other organizations.
“bullwhip effect” or “whiplash effect”

Differentiate materials
requirements planning (MRP)
systems from just-in-time (JIT)
systems for manufacturing.

Materials Requirement
Planning (MRP)
Materials requirements planning (MRP)

systems take a “push-through” approach
that manufactures finished goods for
inventory on the basis of demand forecasts.
MRP predetermines the necessary outputs
at each stage of production.

Materials Requirement
Planning (MRP)
Management accountants play key roles in
an MRP system, including...
– maintaining accurate and timely information
pertaining to materials, work in process,
and finished goods, and...
– providing estimates of the setup costs for each
production run, the downtime costs,
and carrying costs of inventory.
Identify the features of a

just-in-time production system.

Just-In-Time Production Systems
Just-in-time (JIT) production systems take a

“demand pull” approach in which goods are
only manufactured to satisfy customer orders.

Major Features of a JIT System
1. Organizing production in manufacturing cells

2. Hiring and retaining multi-skilled workers
3. Emphasizing total quality management
4. Reducing manufacturing lead time and setup time
5. Building strong supplier relationships

Major Features of a JIT System
What information may management accountants use?
Personal observation by production

line workers and managers
Financial performance measures,
such as inventory turnover ratios
Nonfinancial performance measures
of time, inventory, and quality.
Use backflush costing.

Backflush Costing
Backflush costing describes a costing

system that delays recording some or
all of the journal entries relating to the
cycle from purchase of direct materials
to the sale of finished goods.

Backflush Costing
Where journal entries for one or more stages

in the cycle 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.

Describe different ways

backflush costing can simplify
traditional job-costing systems.

Trigger Points
The term trigger point refers to a stage in a cycle

going from purchase of direct materials to sale
of finished goods at which journal entries are
made in the accounting system.

Trigger Points
Stage A: Stage B:
Purchase of Production resulting
direct materials in work in process
Stage C: Stage D:
Completion of good Sale of
units of product finished goods
Trigger Points
Assume trigger points A, C, and D.

This company would have two inventory accounts:
Type Account Title

1. Combined materials 1. Inventory:
and materials in work Raw and In-process
in process inventory Control
2. Finished goods 2. Finished Goods Control
Trigger Points
What is the journal entry when trigger point A occurs?

Inventory: Raw and In-process Control XX
Accounts Payable Control XX
To record direct material purchased during the period

Trigger Points
What is the journal entry to record conversion costs?

Conversion Costs Control XX
Various accounts XX
To record the incurrence of conversion costs during
the accounting period
Underallocated or overallocated conversion costs
are written off to cost of goods sold.
Trigger Points
What is the journal entry when trigger point C occurs?

Finished Goods Control XX
Inventory: Raw and
In-Process Control XX
Conversion Costs Allocated XX
To record the cost of goods completed during the
accounting period
Trigger Points
What is the journal entry when trigger point D occurs?

Cost of Goods Sold XX
Finished Goods Control XX
To record the cost of goods sold during the
accounting period

Trigger Points
Assume trigger points A and D.

This company would have one inventory account:
Type Account Title

Combines direct materials
inventory and any direct Inventory Control
materials in work in process
and finished goods inventories
Trigger Points
What is the journal entry when trigger point A occurs?

Inventory: Raw and In-process Control XX
Accounts Payable Control XX
To record direct material purchased during the period
Same as the A, C, and D example.

Trigger Points
What is the journal entry to record conversion costs?

Conversion Costs Control XX
Various accounts XX
To record the incurrence of conversion costs during
the accounting period
Same as the A, C, and D example.

Trigger Points
What is the journal entry to record the
cost of goods completed during the
accounting period (trigger point C)?
No journal entry.

Trigger Points
What is the journal entry when trigger point D occurs?

Cost of Goods Sold XX
Inventory Control XX
Conversion Costs Allocated XX
To record the cost of goods sold during the
accounting period

End of Chapter 20

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

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Inventory Management,

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 1

Identify five categories of costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 2

1. Purchasing costs include transportation costs.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 3

4. Stockout costs occur when an organization

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 4

Balance ordering costs with

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 5

1. The same quantity is ordered at each

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 6

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 7

The EOQ minimizes the relevant ordering

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 8

Annual demand is 12,844 packages, at the

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 9

Relevant ordering cost per purchase order: $209

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 10

D = Demand in units for a specified time period

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 11

2 x12 ,844 x$209

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 12

What are the relevant total costs (RTC)?

Q can be any order quantity, not just the EOQ.

When Q = 988 units,

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 14

4,000 Annual relevant

600 988 1,200 1,800 2,400

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 16

Safety stock is inventory held at all times

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 18

How much safety stock should be carried?

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 19

What are the relevant incremental costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 20

Predicting relevant costs requires care

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 21

Step 1: Compute the monetary outcome

EOQ = 456 ,966 = 676 packages

The annual relevant total costs when EOQ is

RTC = (12,844 × $97.84 ÷ 676) + (676 × $5.50 ÷ 2)

Step 2: Compute the monetary outcome

2 x12 ,844 x$209

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 24

What are the annual relevant costs using

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 25

Step 3: Compute the difference between

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 26

Identify and reduce conflicts

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 27

The opportunity cost of investment tied up

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 28

Just-in-time (JIT) purchasing is the purchase

The cost of placing a purchase order

2. Companies are using electronic links,

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 31

Use a supply-chain approach

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 32

Supply-chain analysis describes the flow

“bullwhip effect” or “whiplash effect”

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 33

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster 20 - 34