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20-1
CHAPTER 20
INVENTORY MANAGEMENT, JUST-IN-TIME,
AND SIMPLIFIED COSTING METHODS
20-1 Cost of goods sold (in retail organizations) or direct materials costs (in organizations with
a manufacturing function) as a percentage of sales frequently exceeds net income as a percentage
of sales by many orders of magnitude. In the Kroger grocery store example cited in the text, cost
of goods sold to sales is 79.4%, and net income to sales is 1.5%. Thus, a 10% reduction in the ratio
of cost of goods sold to sales (79.4 to 71.5% equal to 7.9%) without any other changes can result
in a 527% increase in net income to sales (1.5% plus 7.9% equal to 9.4%).
20-2 Six cost categories important in managing goods for sale in a retail organization are the
following:
1. Purchasing costs
2. Ordering costs
3. Carrying costs
4. Stockout costs
5. Costs of quality
6. Shrinkage costs
20-3 Five assumptions made when using the simplest version of the EOQ model are the
following:
1. The same quantity is ordered at each reorder point.
2. Demand, ordering costs, carrying costs, and the purchase-order lead time are certain.
3. Purchasing cost per unit is unaffected by the quantity ordered.
4. No stockouts occur.
5. Costs of quality and shrinkage costs are considered only to the extent that these costs affect
ordering costs or carrying costs.
20-4 Costs included in the carrying costs of inventory are incremental costs for such items as
insurance, rent, and obsolescence plus the opportunity cost of capital (or required return on
investment).
20-5 Examples of opportunity costs relevant to the EOQ decision model but typically not
recorded in accounting systems are the following:
1. The return forgone by investing capital in inventory
2. Lost contribution margin on existing sales when a stockout occurs;
3. Lost contribution margin on potential future sales that will not be made to disgruntled
customers
20-6 The steps in computing the costs of a prediction error when using the EOQ decision model
are: Step 1: Compute the monetary outcome from the best action that could be taken, given
the actual amount of the cost input.
Step 2: Compute the monetary outcome from the best action based on the incorrect
amount of the predicted cost input.
Step 3: Compute the difference between the monetary outcomes from Steps 1 and 2.
20-2
20-7 Goal congruence issues arise when there is an inconsistency between the EOQ decision
model and the model used for evaluating the performance of the person implementing the model.
For example, if opportunity costs are ignored in performance evaluation, the manager may be
induced to purchase in a quantity larger than the EOQ model indicates is optimal.
20-8 Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that they are
delivered just as needed for production (or sales). Benefits include lower inventory holdings
(reduced warehouse space required and less money tied up in inventory) and less inventory
obsolescence and spoilage. The risk in JIT purchasing is the risk of stockouts—delays in supply
of materials (or goods) may result in materials (goods) not being available when needed for
production (or sales).
20-9 Factors causing reductions in the cost to place purchase orders of materials are the
following:
• Companies are establishing long-run purchasing agreements that define price and
quality terms over an extended period.
• Companies are using electronic links, such as the Internet, to place purchase orders.
• Companies are increasing the use of purchase-order cards.
20-10 Disagree. Choosing the supplier who offers the lowest price will not necessarily result in
the lowest total purchase cost to the buyer. This is because the price or purchase cost of the goods
is only one—and perhaps, most obvious—element of cost associated with purchasing and
managing inventories. Other relevant cost items are ordering costs, carrying costs, stockout costs,
quality costs, and shrinkage costs. A low-cost supplier may well impose conditions on the buyer—
such as poor quality or frequent stockouts or excessively high inventories—that result in high total
costs of purchase. Buyers must examine all the elements of costs relevant to inventory
management, not just the purchase price.
20-11 Supply-chain analysis 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
Sharing of information across companies benefits manufacturers and retailers because it enables a
reduction in inventory levels at all stages of the supply chain, fewer stockouts at the retail level,
reduced manufacture of product not subsequently demanded by retailers, and a reduction in
expedited manufacturing orders.
20-12 Just-in-time (JIT) 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. It has the following features:
• Organize production in manufacturing cells.
• Hire and retain workers who are multi-skilled.
• Aggressively pursue total quality management (TQM) to eliminate defects.
• Place emphasis on reducing both setup time and manufacturing cycle time.
• Carefully select suppliers who are capable of delivering quality materials in a timely
manner.
The benefits of JIT production include lower costs and higher margins from better flow of
information, higher quality, and faster delivery, as well as simpler accounting systems. The cost
20-3
of JIT production is the risk of stockouts—a production problem in any step of the manufacturing
process will result in materials (goods) not being produced in time.
20-12 Traditional normal and standard costing systems use sequential tracking, in which journal
entries are recorded in the same order as actual purchases and progress in production,
typically at four different trigger points in the process.
Backflush costing omits recording some of the journal entries relating to the cycle from
purchase of direct materials to sale of finished goods, i.e., it has fewer trigger points at which
journal entries are made. When 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.
20-14 Versions of backflush costing differ in the number and placement of trigger points at which
journal entries are made in the accounting system:
Number of
Journal Entry
Trigger Points
Location in Cycle Where
Journal Entries Made
Version 1
3
Stage A. Purchase of direct materials and incurring of
conversion costs
Stage C. Completion of good finished units of product
Stage D. Sale of finished goods
Version 2
2
Stage A. Purchase of direct materials and incurring of
conversion costs
Stage D. Sale of finished goods
Version 3
2
Stage C. Completion of good finished units of product
Stage D. Sale of finished goods
20-15 Traditional accounting systems cost individual products and separate product costs from
selling, general, and administrative costs. Lean accounting costs the entire value stream instead
of individual products. Rework costs, unused capacity costs, and common costs that cannot be
reasonably assigned to value streams are excluded from value stream costs. In addition, many
lean accounting systems expense material costs in the period they are purchased, rather than
storing them on the balance sheet until the products using the material are sold.
20-16 (20 min.) Economic order quantity for retailer.
Fan Base (FB) operates a megastore featuring sports merchandise. It uses an EOQ decision model
to make inventory decisions. It is now considering inventory decisions for its Los Angeles Galaxy
soccer jerseys product line. This is a highly popular item. Data for 2013 are as follows:
20-4
Each jersey costs FB $40 and sells for $80. The $7 carrying cost per jersey per year consists of the
required return on investment of $4.80 (12% × $40 purchase price) plus $2.20 in relevant
insurance, handling, and storage costs. The purchasing lead time is 7 days. FB is open 365 days a
year.
Required:
1. Calculate the EOQ.
2. Calculate the number of orders that will be placed each year.
3. Calculate the reorder point.
SOLUTION
1. D = 10,000 jerseys per year, P = $200, C = $7 per jersey per year
7
200$000,102
C
DP 2
EOQ
==
= 755.93 756 jerseys
2. Number of orders per year =
EOQ
D
=
756
000,10
= 13.22 14 orders
3.
day working each Demand
=
days workingofNumber
D
=
365
000,10
= 27.40 jerseys per day
Purchase lead time = 7 days
Reorder point = 27.40 7
= 191.80 192 jerseys
20-17 (20 min.) Economic order quantity, effect of parameter changes (continuation of 20-16).
Athletic Textiles (AT) manufactures the Galaxy jerseys that Fan Base (FB) sells to its customers.
AT has recently installed computer software that enables its customers to conduct “one-stop”
purchasing using state-of-the-art Web site technology. FB’s ordering cost per purchase order will
be $30 using this new technology.
Required:
1. Calculate the EOQ for the Galaxy jerseys using the revised ordering cost of $30 per purchase
order. Assume all other data from Exercise 20-16 are the same. Comment on the result.
2. Suppose AT proposes to “assist” FB. AT will allow FB customers to order directly from the
AT Web site. AT would ship directly to these customers. AT would pay $10 to FB for every
Galaxy jersey purchased by one of FB’s customers. Comment qualitatively on how this offer
would affect inventory management at FB. What factors should FB consider in deciding
whether to accept AT’s proposal?
20-5
SOLUTION
1. D = 10,000 jerseys per year, P = $30, C = $7 per jersey per year
7
30$000,102
C
DP 2
EOQ
==
= 292.77 jerseys 293 jerseys
The sizable reduction in ordering cost (from $200 to $30 per purchase order) has reduced the EOQ
from 756 to 293.
2. The AT proposal has both upsides and downsides. The upside is potentially higher sales.
FB customers may purchase more online than if they have to physically visit a store. As a result
of the proposal, FB would have lower administrative costs and would need to hold lower
inventories (as more sales occur directly through AT’s Web site) resulting in lower inventory
carrying costs.
The downside is that AT could capture FB’s customers. Repeat customers to the AT Web
site need not be classified as FB customers. FB would have to establish enforceable rules to make
sure it captures ongoing revenues from customers it directs to the AP Web site.
There is insufficient information to determine whether FB should accept AT’s proposal.
Much depends on whether FB views AT as a credible, “honest” partner.
20-18 (15 min.) EOQ for a retailer.
The Denim World sells fabrics to a wide range of industrial and consumer users. One of the
products it carries is denim cloth, used in the manufacture of jeans and carrying bags. The supplier
for the denim cloth pays all incoming freight. No incoming inspection of the denim is necessary
because the supplier has a track record of delivering high-quality merchandise. The purchasing
officer of the Denim World has collected the following information:
The purchasing lead time is 2 weeks. The Denim World is open 250 days a year (50 weeks for 5
days a week).
Required:
1. Calculate the EOQ for denim cloth.
2. Calculate the number of orders that will be placed each year.
20-6
3. Calculate the reorder point for denim cloth.
SOLUTION
1. D = 26,400 yards per year, P = $165, C = 20% $9 = $1.80 per yard per year
2 26,400 $165
2 DP
EOQ 2,200 yards
C $1.80
= = =
2. Number of orders per year:
D 26,400 12 orders per year
EOQ 2,200
==
3. Demand each working day = D
Number of working days
=
26,400
250
= 105.60 yards per day
= 528 yards per week (105.60 × 5 days per week)
Purchasing lead time = 2 weeks
Reorder point = 528 yards per week 2 weeks = 1,056 yards
20-19 (20 min.) EOQ for manufacturer.
Turfpro Company produces lawn mowers and purchases 4,500 units of a rotor blade part each year
at a cost of $30 per unit. Turfpro requires a 15% annual rate of return on investment. In addition,
the relevant carrying cost (for insurance, materials handling, breakage, etc.) is $3 per unit per year.
The relevant ordering cost per purchase order is $75.
Required:
1. Calculate Turfpro’s EOQ for the rotor blade part.
2. Calculate Turfpro’s annual relevant ordering costs for the EOQ calculated in requirement 1.
3. Calculate Turfpro’s annual relevant carrying costs for the EOQ calculated in requirement 1.
4. Assume that demand is uniform throughout the year and known with certainty so there is no
need for safety stocks. The purchase-order lead time is half a month. Calculate Turfpro’s
reorder point for the rotor blade part.
SOLUTION
1. Relevant carrying costs per part per year:
Required annual return on investment 15% $30 = $4.50
Relevant insurance, materials handling, breakage, etc.
costs per year 3.00
Relevant carrying costs per part per year $7.50
With D = 4,500 parts per year; P = $75; C = $7.50 per part per year, EOQ for manufacturer is:
20-7
2 DP 2 4,500 $75
EOQ C 7.50
= = =
300 units
2.
Relevant annual
ordering costs
=
D P
Q
=
4,500 $75
300
= $1,125
where Q = 300 units, the EOQ.
3. At the EOQ, total relevant ordering costs and total relevant carrying costs will be exactly
equal. Therefore, total relevant carrying costs at the EOQ = $1,125 (from requirement 2). We can
also confirm this with a direct calculation:
Relevant annual carrying costs
=
Q C
2
=
300 $7.50
2
= $1,125
where Q = 300 units, the EOQ.
4. Purchase order lead time is half a month.
Monthly demand is 4,500 units ÷ 12 months = 375 units per month.
Demand in half a month is 1
2 375 units or 188 units.
Turfpro should reorder when the inventory of rotor blades falls to 188 units.
20-20 (20 min.) Sensitivity of EOQ to changes in relevant ordering and carrying costs.
Alpha Company’s annual demand for its only product, XT-590, is 10,000 units. Alpha is currently
analyzing possible combinations of relevant carrying cost per unit per year and relevant ordering
cost per purchase order, depending on the company’s choice of supplier and average levels of
inventory. This table presents three possible combinations of carrying and ordering costs.
Required:
1. For each of the relevant ordering and carrying-cost alternatives, determine (a) EOQ and (b)
annual relevant total costs.
20-8
2. How does your answer to requirement 1 give insight into the impact of changes in relevant
ordering and carrying costs on EOQ and annual relevant total costs? Explain briefly.
3. Suppose the relevant carrying cost per unit per year was $20 and the relevant ordering cost per
purchase order was $200. Suppose further that Alpha calculates EOQ after incorrectly
estimating relevant carrying cost per unit per year to be $10 and relevant ordering cost per
purchase order to be $400. Calculate the actual annual relevant total costs of Alpha’s EOQ
decision. Compare this cost to the annual relevant total costs that Alpha would have incurred
if it had correctly estimated the relevant carrying cost per unit per year of $20 and the relevant
ordering cost per purchase order of $200 that you have already calculated in requirement 1.
Calculate and comment on the cost of the prediction error.
SOLUTION
1. A straightforward approach to the requirement is to construct the following table for EOQ
at relevant carrying and ordering costs. Annual demand is 10,000 units. The formula for the EOQ
model is:
EOQ =
2DP DP QC
and for Relevant Total Costs (RTC) =
C Q 2
+
where D = demand in units per year
P = relevant ordering costs per purchase order
C = relevant carrying costs of one unit in stock for the time period used for D (one year in
this problem.
Relevant
Carrying
Costs per Unit
per Year
(C)
Relevant
Ordering
Costs per
Purchase
Order
(P)
$10 $400
2 10,000 $400 10,000 $400 895 $10
EOQ = 895, RTC= $8,944
$10 895 2
= + =
$20 $200
2 10,000 $200 10,000 $200 447 $20
EOQ = 447, RTC= $8,944
$20 447 2
= + =
$40 $100
2 10,000 $100 10,000 $100 224 $40
EOQ = 224, RTC= $8,944
$40 224 2
= + =
2. For a given demand level, as relevant carrying costs increase and relevant ordering costs
decrease, EOQ becomes smaller. That is EOQ decreases to compensate for increases in carrying
costs and to take advantage of decreases in ordering costs. That is, the EOQ offsets the effect on
total costs of the increase in carrying costs and the decrease in ordering costs.
In this example, the change in EOQ results in relevant total costs (RTC) being the same
across all three cases. The fact that the total costs are the same is a function of the specific
numbers chosen in this example. For example, in the last combination, if relevant carrying costs
20-9
per unit per year were $35 instead of $40 and relevant ordering costs per purchase order
remained at $100, the relevant total costs would equal $8,367.
2 10,000 $100 10,000 $100 239 $35
EOQ = 239, RTC= $8,367
$35 239 2
= + =
3. If Alpha estimates C = $10 per unit per year and P = $400 per order, then from
requirement 1,
EOQ = 224 units and Relevant Total Cost (RTC) = $8,944
For EOQ = 224 units, C = $20 per unit per year and P = $200 per order,
Relevant total costs (RTC) =
DP QC
Q2
+
10,000 $200 224 $20
224 2
=+
= $8,929 + $2,240 = $11,169
The prediction error equals $11,169 – $8,944 = $2,225, which is 25% ($2,225 ÷ $8,944) of the
relevant total cost had there been no prediction error. The error in prediction results in a
significantly higher cost but is still limited, given that the estimate of the carrying cost was half
the actual amount and the estimate of the ordering cost was twice the actual amount. The square
root function dampens the effect of the errors.
20-21 (20 min.) JIT production, relevant benefits, relevant costs.
The Colonial Hardware Company manufactures specialty brass door handles at its Lynchburg
plant. Colonial is considering implementing a JIT production system. The following are the
estimated costs and benefits of JIT production:
a. Annual additional tooling costs would be $200,000.
b. Average inventory would decline by 80% from the current level of $2,000,000.
c. Insurance, space, materials-handling, and setup costs, which currently total $600,000 annually,
would de- cline by 25%.
d. The emphasis on quality inherent in JIT production would reduce rework costs by 30%.
Colonial currently incurs $400,000 in annual rework costs.
e. Improved product quality under JIT production would enable Colonial to raise the price of its
product by $8 per unit. Colonial sells 40,000 units each year.
Colonial’s required rate of return on inventory investment is 15% per year.
Required:
1. Calculate the net benefit or cost to Colonial if it adopts JIT production at the Lynchburg plant.
2. What nonfinancial and qualitative factors should Colonial consider when making the decision
to adopt JIT production?
3. Suppose Colonial implements JIT production at its Lynchburg plant. Give examples of
performance measures Colonial could use to evaluate and control JIT production. What would
be the benefit of Colonial implementing an enterprise resource planning (ERP) system?
20-10
SOLUTION
1. Solution Exhibit 20-21 presents the annual net benefit of $630,000 to Colonial Hardware
Company of implementing a JIT production system.
2. Other nonfinancial and qualitative factors that Colonial should consider in deciding
whether it should implement a JIT system include:
a. The possibility of developing and implementing a detailed system for integrating the
sequential operations of the manufacturing process. Direct materials must arrive when
needed for each subassembly so that the production process functions smoothly.
b. The ability to design products that use standardized parts and reduce manufacturing
time.
c. The ease of obtaining reliable vendors who can deliver quality direct materials on time
with minimum lead time.
d. Willingness of suppliers to deliver smaller and more frequent orders.
e. The confidence of being able to deliver quality products on time. Failure to do so would
result in customer dissatisfaction.
f. The skill levels of workers to perform multiple tasks such as minor repairs,
maintenance, quality testing and inspection.
3. Personal observation by production line workers and managers is more effective in JIT
plants than in traditional plants. A JIT plant’s production process layout is streamlined. Operations
are not obscured by piles of inventory or rework. As a result, such plants are easier to evaluate by
personal observation than are cluttered plants where the flow of production is not logically laid
out.
Besides personal observation, nonfinancial performance measures are the dominant
methods of control. Nonfinancial performance measures provide most timely and easy to
understand measures of plant performance. Examples of nonfinancial performance measures of
time, inventory, and quality include the following:
• Manufacturing lead time
• Units produced per hour
• Machine setup time ÷ manufacturing time
• Number of defective units ÷ number of units completed
In addition to personal observation and nonfinancial performance measures, financial performance
measures are also used. Examples of financial performance measures include the following:
• Cost of rework
• Ordering costs
• Stockout costs
• Inventory turnover (cost of goods sold
average inventory)
The success of a JIT system depends on the speed of information flows from customers
to manufacturers to suppliers. The Enterprise Resource Planning (ERP) system has a single
database and gives lower-level managers, workers, customers, and suppliers access to operating
information. This benefit, accompanied by tight coordination across business functions, enables
20-11
the ERP system to rapidly transmit information in response to changes in supply and demand so
that manufacturing and distribution plans may be revised accordingly.
