COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 1 Chapter 21 Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints

2 Study Objectives 1.Describe the just-in-case inventory management model. 2.Discuss just-in-time (JIT) inventory management. 3.Explain the basic concepts of constrained optimization. 4.Define the theory of constraints, and tell how it can be used to manage inventory.

3 Just-in-Case Inventory Management Three types of inventory costs can be readily identified with inventory: –The cost of acquiring inventory. –The cost of holding inventory. –The cost of not having inventory on hand when needed.

4 Just-in-Case Inventory Management Ordering Costs: The costs of placing and receiving an order. Examples: Clerical costs, documents, insurance for shipment, and unloading. Setup Costs: The costs of preparing equipment and facilities so they can be used to produce a particular product or component. Examples: Setup labor, lost income (from idled facilities), and test runs.

5 Just-in-Case Inventory Management Stock-Out Costs: The costs of not having sufficient inventory. Examples: Lost sales, costs of expediting (extra setup, transportation, etc.) and the costs of interrupted production. Carrying Costs: The costs of carrying inventory. Examples: Insurance, inventory taxes, obsolescence, opportunity cost of capital tied up in inventory, and storage.

6 Just-in-Case Inventory Management

7 Economic Order Quantity TC = PD/Q + CQ/2 Just-in-Case Inventory Management Where TC =The total ordering (or setup) and carrying cost P =The cost of placing and receiving an order (or the cost of setting up a production run) Q =The number of units ordered each time an order is placed (or the lot size for production) D =The known annual demand C =The cost of carrying one unit of stock for one year

8 Just-in-Case Inventory Management Economic Order Quantity illustrated Assume P =$40 per order D =25,000 units C =$2 per unit

9 Just-in-Case Inventory Management Reorder point= rate of usage × lead time = 4 × 100 = 400 units An order should be placed when inventory drops to 400 units. When to Order or Produce Example: Assume that the average rate of usage is 100 parts per day. Assume also that the lead time is 4 days. What is the reorder point?

10 Just-in-Case Inventory Management

11 Demand Uncertainty and Reordering To avoid running out of parts, organizations often choose to carry safety stock (extra inventory carried to serve as insurance against fluctuations in demand). Example: If the maximum usage of the VCR part is 120 units per day, the average usage is 100 units per day, and the lead time is four days, the safety stock is 80. Maximum usage120 Average usage(100) Difference20 Lead time × 4 Safety stock80 Just-in-Case Inventory Management

12 Just-in-Case Inventory Management

13 JIT Inventory Management JIT reduces the costs of acquiring inventory to insignificant levels by –Drastically reducing setup time –Using long-term contracts for outside purchases Carrying costs are reduced to insignificant levels by reducing inventories to insignificant levels. Setup and Carrying Costs: The JIT Approach

14 JIT Inventory Management Avoidance of Shutdown: the JIT approach Total preventive maintenance –to reduce machine failures Total quality control –To reduce defective parts The Kanban system –To control production

15 JIT Inventory Management The Kanban system is responsible for ensuring that the necessary products are produced in the necessary quantities at the necessary time. A card system is used to monitor work in process –A withdrawal Kanban –A production Kanban –A vendor Kanban

16 JIT Inventory Management

17 JIT Inventory Management

18 JIT Inventory Management Managing discounts and price increases –Traditional: holding inventories –JIT: negotiate long-term contracts Vendors –Careful selection; consider more than price –Close to production facility –Establish more extensive supplier involvement

19 JIT Inventory Management JIT Limitations Patience in implementation is needed. Time is required. JIT may cause lost sales and stressed workers. Production may be interrupted due to an absence of inventory.

20 Basic Concepts of Constrained Optimization Every firm faces limited resources and limited demand for each product. –External constraints (e.g., market demand) –Internal constraints (e.g., machine or labor time availability) Constrained optimization is choosing the optimal mix given the constraints faced by the firm.

21 Linear Programming Example: Two products, X and Y, provide contribution margins of $300 and $600, respectively. The objective is to maximize total contribution margin. The objective function: Z = $300X + $600Y Basic Concepts of Constrained Optimization A method that searches among possible solutions until the optimal solution is identified

22 Linear Programming Basic Concepts of Constrained Optimization

23 Basic Concepts of Constrained Optimization Internal constraints: External constraints: Linear Programming

24 Basic Concepts of Constrained Optimization

25 A00$ 0 B04024,000 C303027,000 D45013,500 Linear Programming Corner Point X-Value Y-Value Z = $300X + $600Y C is the optimal solution! Basic Concepts of Constrained Optimization

26 Theory of Constraints Measures of Systems Performance –Throughput* The rate at which an organization generates money through sales –Inventory The money the organization spends in turning materials into throughput –Operating expenses The money the organization spends in turning inventories into throughput *Throughput =

27 Theory of Constraints Five-Step Method for Improving Performance Identify an organization’s constraints. Exploit the binding constraints. Subordinate everything else to the decisions made in Step 2. Elevate the organization’s binding constraints. Repeat the process as a new constraint emerges to limit output.

28 Theory of Constraints

29 Theory of Constraints

30 Theory of Constraints

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 31 End Chapter 21