Inventory and Production Management
After reading and studying Chapter 18, you should be able to answer the following questions:
1. What costs are associated with inventory and why is inventory management important to most firms?
2. How do push and pull systems control production?
3. Why do product life cycles affect profitability?
4. What is target costing, and how does it influence production cost management?
5. What is the just-in-time philosophy? What modifications does JIT require in accounting systems?
6. What are flexible manufacturing systems?
7. How can the theory of constraints help in determining production flow?
8. (Appendix) How are economic order quantity, reorder point, and safety stock determined and used?
Autonomation: the use of equipment that has been programmed to sense certain conditions
Backflush costing: a streamlined cost accounting method that speeds up, simplifies, and reduces accounting effort in an environment that minimizes inventory balances, requires few allocations, uses standard costs, and has minimal variances from standard
Bottleneck: any object or facility whose processing speed is sufficiently slow to cause the other processing mechanisms in its network to experience idle time
Computer-integrated manufacturing (CIM): the integration of two or more flexible manufacturing systems through the use of a host computer and an information networking system
Constraint: a restriction inhibiting the achievement of an objective
Cost table: a database providing information about the impact on product costs of using different input resources, manufacturing processes, and design specifications
Economic order quantity (EOQ): an estimate of the number of units per order that will be the least costly and provide the optimal balance between the costs of ordering and the costs of carrying inventory
Economic production run (EPR): an estimate of the number of units to produce at one time that minimizes the total costs of setting up production runs and carrying inventory
Flexible manufacturing system (FMS): a production system in which a single factory manufactures numerous variations of products through the use of computer-controlled robots
Focused factory arrangement: an arrangement in which a vendor (which may be an external party or an internal corporate division) agrees to provide a limited number of products according to specifications or to perform a limited number of unique services for a company that is typically operating on a just-in-time system
Internet business model: a model that involves (1) few physical assets, (2) little management hierarchy, and (3) a direct pipeline to customers
Just-in-time (JIT): a philosophy about when to do something; the when is ¡°as needed¡± and the something is a production, purchasing, or delivery activity
Just-in-time manufacturing system: a production system that attempts to acquire components and produce inventory only as needed, to minimize product defects, and to reduce lead/setup times for acquisition and production
Kaizen costing: a costing technique to reflect continuous efforts to reduce product costs, improve product quality, and/or improve the production process after manufacturing activities have begun
Kanban: the Japanese word for card; it was the original name for a JIT system because of the use of cards that indicated a work center¡¯s need for additional components during a manufacturing process
Lead time: the time between the placement of an order to the time the goods arrive for usage or are produced by the company; it is equal to value-added time plus non-value-added time
Lean manufacturing: approach in which the manufacturer makes only those items demanded by customers and attempts to make those items without waste
Manufacturing cell: a linear or U-shaped production grouping of workers or machines
Molecular manufacturing: a future technology based on Feynman¡¯s vision of factories using nanomachines to build complex products; such an approach should bring great improvements in the cost and performance of manufactured goods (from www.e-drexler.com/p/04/03/0325molManufDef.html)
Order point: the level of inventory that triggers the placement of an order for additional units; it is a function of usage, lead time, and safety stock
Pareto inventory analysis: an analysis that separates inventory into three groups based on annual cost-to-volume usage
Product life cycle: a model depicting the stages through which a product class (not each product) passes from the time that an idea is conceived until production is discontinued
Pull system: a production system dictated by product sales and demand; a system in which parts are delivered or produced only as they are needed by the work center for which they are intended; it requires only minimal storage facilities
Purchasing cost: the quoted price of inventory minus any discounts allowed plus shipping charges
Push system: the traditional production system in which work centers produce inventory that is not currently needed because of lead time or economic production/order requirements; it requires that excess inventory be stored until needed
Red-line system: an inventory ordering system in which a red line is painted on the inventory container at a point deemed to be the reorder point
Safety stock: a buffer level of inventory kept on hand by a company in the event of fluctuating usage or unusual delays in lead time
Six-sigma method: a high-performance, data-driven approach to analyzing and solving the root causes of business problems
Supply-chain management: the cooperative strategic planning, controlling, and problem solving by a company and its vendors and customers to conduct efficient and effective transfers of goods and services within the supply chain
Target costing: a method of determining what the cost of a product should be based on the product¡¯s estimated selling price less the desired profit
Theory of constraints (TOC): a method of analyzing the bottlenecks (constraints) that keep a system from achieving higher performance since production cannot take place at a rate faster than the slowest machine or person in the process
Two-bin system: an inventory ordering system in which two containers (or stacks) of raw materials or parts are available for use; when one container is depleted, the removal of materials from the second container begins and a purchase order is placed to refill the first container
Usage: the quantity of inventory used or sold each time interval
Value engineering: a disciplined search for various feasible combinations of resources and methods that will increase product functionality and reduce costs
Virtual reality: an artificial, computer-generated environment in which the user has the impression of being part of the environment and has the ability to navigate and manipulate objects (such as products) behaving like real-world objects
LO.1: What costs are associated with inventory and why is inventory management important to most firms?
1. This chapter deals with ways companies minimize their monetary commitments to inventory while still satisfying customer demands.
a. The chapter appendix covers the concepts of economic order quantity (EOQ), order point, safety stock, and Pareto inventory analysis.
B. Important Relationships in the Value Chain
1. Every company has a set of upstream suppliers and a set of downstream customers. These upstream suppliers and downstream customers link together to form a value chain.
a. It is at the interfaces of these relationships where real opportunities for improvements exist.
2. By building improved cooperation, communication, and integration, the entities within the value chain can treat each other as extensions of themselves.
3. Non-value-added activities can be reduced or eliminated and performance of value-added activities can be enhanced; shared expertise and problem solving can be very beneficial.
4. Products and services can be provided faster and with fewer defects, and activities can be performed more effectively and reliably with less deficiencies and redundancy. Consider the following opportunities for improvement between each entity:
a. improved communication of requirements and specifications;
b. greater clarity in requests for products or services;
c. improved feedback regarding unsatisfactory products or services;
d. improvements in planning, controlling, and problem solving; and
e. shared managerial and technical expertise, supervision, and training.
5. If employees perceive their internal suppliers and customers as extensions of themselves and work to exploit the previous opportunities, teamwork will be significantly enhanced.
6. Improved teamwork helps companies in their implementation of pull systems, which are part of a just-in-time work environment. Increased productivity benefits all company stakeholders by:
a. reducing investment in inventory;
b. improving cash-to-cash cycle time;
c. generating higher asset turnover;
d. generating higher inventory turnover; and
e. reducing inventory risk.
C. Buying or Producing and Carrying Inventory
1. Organizations can increase their profit margins by reducing or minimizing inventory investments, assuming that the demand for products can still be met.
a. The term inventory is used to refer to any of the following: raw material, work in process, finished goods, indirect material (supplies), or merchandise inventory.
2. Raw material cost can be a major cost for manufacturing companies, and raw material purchases cause an ongoing cash outflow each period.
a. Retailers invest a substantial share of their assets in merchandise purchased for sale to others.
3. Good inventory management relies mostly on cost-minimization strategies.
a. As indicated in text Exhibit 18-1, there are three basic costs associated with inventory:
ii. ordering/setup; and
iii. carrying/not carrying goods in stock.
4. The purchasing cost of inventory is the quoted purchase price of inventory, minus any discounts allowed, plus shipping charges.
5. Production cost for a manufacturer refers to the costs associated with purchasing direct materials, paying for direct labor, incurring traceable overhead, and absorbing allocated fixed manufacturing overhead.
LO.2: How do push and pull systems control production?
6. The two theoretical approaches to producing inventory are push systems and pull systems.
a. A push system is the traditional production system in which work centers may produce inventory that is not currently needed because of lead time or economic production/order requirements; it requires that excess inventory be stored until needed (See text Exhibit 18-2).
b. A pull system is a production system dictated by product sales and demand; it is a system in which parts are delivered or produced only as they are needed by the work center for which they are intended; it requires only minimal storage facilities (See text Exhibit 18-3).
LO.3: Why do product life cycles affect profitability?
D. Understanding and Managing Production Activities and Costs
1. Product life cycles
a. The product life cycle is a model depicting the stages through which a product class (not necessarily each product) passes.
i. A product¡¯s life cycle stage can have a tremendous impact on costs, sales, and pricing strategies.
b. The five specific product life cycle stages are:
i. development (which includes design);
¡¤ See the next section in this outline.
¡¤ Costs can be substantial and are typically related to orders changes, market research, advertising, and promotion. Sales are usually low and prices are often set in relationship to the market price of similar or substitute goods.
¡¤ The growth stage begins when the product has been accepted by the market and begins to show increased sales. Product quality also can improve, especially if competitors have improved on original production designs. Prices are fairly stable because many substitutes exist or because consumers have become attached to the product and are willing to pay a particular price for it rather than buy a substitute.
iv. maturity; and
¡¤ Sales begin to stabilize or slowly decline and firms often compete on the basis of selling price. Costs are often at their lowest level during this period, so profits can be high. Some products remain at this stage for a very long time.
¡¤ Sales begin to wane. Prices must be cut dramatically to stimulate business. Production costs per unit generally increase during this stage because fixed overhead is spread over a smaller production volume.
c. Text Exhibit 18-4 illustrates a conventional sales trend line as the product class passes through each life cycle stage.
LO.4: What is target costing, and how does it influence production cost management?
2. Lifecycle and target costing
a. Lifecycle costing
i. The development stage is fundamentally ignored by the standard financial accounting model.
ii. Effective development efforts are critical to a product¡¯s profitability, even though development stage time has been greatly reduced by technology and competition.
iii. Many manufacturers are keenly aware of the need to target attention on the product development stage and of the ¡°time-to-market¡± as a critical performance measure.
iv. One technology that is increasingly used in the design stage is virtual reality.
¡¤ Virtual reality is an artificial, computer-generated environment in which the user has the impression of being part of that environment and has the ability to navigate and manipulate objects (such as products) behaving like real-world objects.
¡¤ With virtual reality, much of the testing of new products can focus on a virtual prototype rather than a real prototype.
b. Target costing
i. Target costing is a technique that is used to determine what the cost of a product should be, based on the estimated selling price of the product less the desired profit.
ii. It is used by the Japanese to estimate an allowable product cost by applying market research to estimate how much the market will pay for a product with specific characteristics.
iii. As expressed in the following formula, target costing develops an ¡°allowable¡± product cost by analyzing market research to estimate what the market will pay for a product with specific characteristics.
TC = ESP - APM
TC = target cost
ESP = estimated selling price
APM = acceptable profit margin
iv. Subtracting an acceptable profit margin from the estimated selling price leaves an implied maximum per-unit target product cost, which is compared to an expected product cost.
v. A company has several alternatives if the expected cost is higher than the target cost.
¡¤ Cost tables are databases providing information about the impact on product costs of using different input resources, manufacturing processes, and design specifications. They assist in determining how adjustments can be made.
¡¤ A less-than-desired profit margin can be accepted.
¡¤ The company can decide that it does not want to enter this particular product market at the present time since it cannot achieve the desired profit margin.
vi. Value engineering involves a disciplined search for various feasible combinations of resources and methods that will increase product functionality and reduce costs.
vii. Target costing can be applied to a service if it is adequately uniform to justify the necessary modeling effort.
viii. In designing a product to meet an allowable cost, engineers strive to eliminate all nonessential activities from the production process.
¡¤ Properly designed products should require only minimal engineering change orders (EOCs) after being released to production.
¡¤ Each time an ECO is issued, one or more of the following problems can occur and create additional costs: Production documents must be reprinted, workers must relearn tasks, machine dies or setups must be changed, and parts in stock or currently ordered can be made obsolete.
ix. Target costing requires a shift in the way managers think about the relationships among cost, selling price, and profitability.
¡¤ The traditional attitude has been that a product is developed, production cost is identified and measured, a selling price is set (or a market price is met), and profits or losses result.
¡¤ Target costing takes a different perspective: A product is developed, a selling price and desired profit amount are determined, and maximum allowable costs are calculated. When allowable costs are constrained by selling price, all costs must be justified. Unnecessary costs should be eliminated without reducing quality.
x. The target costing process is depicted in text Exhibit 18-5.
c. Kaizen costing involves continuous efforts to reduce product costs, improve product quality, and/or improve the production process after manufacturing activities have begun.
i. Text Exhibit 18-6 compares target costing and Kaizen costing.
LO.5: What is the just-in-time philosophy? What modifications does JIT require in accounting systems?
E. Just-in-Time Systems
1. Just-in-time (JIT) a philosophy about when to do something; the when is ¡°as needed¡± and the something is a production, purchasing, or delivery activity. A JIT system always has three primary goals:
a. elimination of any production process or operation that does not add value to the product/service;
b. continuous improvement in production/performance efficiency; and
c. reduction in the total cost of production/performance while increasing quality.
2. Text Exhibit 18-7 outlines the elements of the JIT philosophy.
3. JIT originated in Japan where a card was used to communicate between work centers.
a. Kanban is the Japanese word for card or ticket; it was the original name for a JIT system because of the use of cards that indicated a work center¡¯s need for additional components during a manufacturing process.
b. A just-in-time (JIT) manufacturing system is a production system that attempts to acquire components and produce inventory only as needed, to minimize product defects, and to reduce lead/setup times for acquisition and production.
4. Production has traditionally been dictated by the need to smooth operating activities over time.
a. Although allowing a company to maintain a steady work force and continuous machine utilization, smooth production often creates products that must be stored until they are sold.
5. Management¡¯s preoccupation with spreading overhead over a maximum number of units of production resulted in much unwanted inventory, huge inventory carrying costs, and other operating problems.
a. Text Exhibit 18¨C8 depicts these inefficiencies or problems as ¡°rocks¡± in a stream of ¡°water¡± that represents inventory.
F. Changes Needed to Implement JIT Manufacturing
a. The most impressive results from JIT are usually reached only after the system has been operational for 5 to 10 years.
b. Implementing JIT takes time and perseverance and a JIT philosophy must have strong backing and resource commitment from top management.
i. Without these ingredients, considerable retraining, and support from all levels of company personnel, JIT implementation will not succeed.
c. Certain modifications must be made in purchasing, supplier relationships, distribution, product design, product processing, and plant layout.
i. JIT depends on the ability of employees and suppliers to compress the time, distance, resources, and activities and to enhance interactions needed to produce a company¡¯s products and services.
2. Supplier relationships and distribution
a. The optimal JIT situation would be to have only one vendor for any given item, but that would create the risk of not having alternative sources in the event of vendor production strikes, unfair pricing, or shipment delays.
i. The realistic and feasible solution is to have a limited number of vendors that are selected and company certified as to quality and reliability.
b. The company then enters into long-term relationships with these suppliers, who become ¡°partners¡± in the process.
c. Vendor certification is becoming increasingly popular. Factors commonly considered in selecting suppliers include: reliability and responsiveness; delivery performance; ability to provide service; personnel qualifications; research and development strength; and production capacity.
d. Forming partnerships with fewer vendors on a long-term basis provides the opportunity to improve quality and reduce costs.
i. Such partnerships permit members of the supply chain to eliminate redundancies in warehousing, packaging, labeling, transportation, and inventories.
3. Product design
a. Products must be designed to use the fewest number of parts and the parts need to be standardized to the extent possible.
i. Parts standardization does not necessarily mean identical products.
b. Products should be designed for the desired quality and should require minimal engineering changes once the design is released for production.
i. Any design changes have to be made early in the process if costs are to be significantly affected.
c. Good product design should address all concerns of the intended consumers including the degree of recycle-ability of the product.
4. Product processing
a. A primary objective of JIT is reduction of machine setup time, which allows processing to rapidly shift among different products at a lower cost.
i. Increases in initial setup time and cost have been found to be more than recovered by the savings from reduction of downtime, work in process inventory, and material handling as well as increasing safety, flexibility, and ease of operation.
ii. Companies implementing such procedures use many low-cost rapid setups rather than using the traditional approach of a small number of expensive setups; setup cost is considered to be almost totally variable rather than fixed.
b. The implementation of high-quality standards that result in zero quality errors is another essential part of JIT product processing.
c. The ability to standardize work so that every worker performs according to stated procedures without variation, on time, every time, is important in JIT as it is in any process.
5. Plant layout
a. The physical plant is arranged in a way that is conducive to the flow of goods and the organization of workers and to increasing the value added per square foot of plant space.
b. Manufacturing cells are linear or U-shaped production groupings of workers or machines.
i. The cells reduce inventory storage, improve material handling and flow, increase machine utilization rates, maximize communication among workers, and result in better quality control (See text Exhibit 18-9).
ii. A streamlined design allows more visual controls to be instituted for such problems as excess inventory, production defects, equipment malfunctions, and out-of-place tools.
c. Text Exhibit 18¨C10 illustrates the flow of three products through a factory before and after the redesign of factory floor space.
d. Multiprocess handling is the ability of a worker to monitor and operate several (or all) machines in a manufacturing cell or perform all steps of a specific task.
e. Autonomation is the use of equipment that has been programmed to sense certain conditions.
G. Logistics of the JIT Environment
1. In a JIT environment, a certain degree of logistical assistance is developing in the areas of information technology (IT), new support services, and new value-chain relationships.
2. The six-sigma method is a high-performance, data-driven approach to analyzing and solving the root causes of business problems. The five steps to the method include:
a. First, the company defines the projects and processes that need improvement;
b. Second, appropriate measurements for success are identified;
c. Third, data are gathered and analyzed to ascertain how the organization is working to achieve its goals;
d. Fourth, improvement projects are designed and instituted; and
e. Fifth, control measures are implemented to sustain performance.
3. The Internet business model is a business model which involves few physical assets, little management hierarchy, and a direct pipeline to customers.
4. Supply-chain management is the cooperative strategic planning, controlling, and problem solving by a company and its vendors and customers to conduct efficient and effective transfers of goods and services within the supply chain.
a. Three levels of business-to-business (B2B) relationships exist in e-commerce: transactional, information-sharing, and collaboration:
i. Transactional relationships include the use of electronic data interchange to automate such things as purchase orders and invoices.
ii. At the information-sharing level, firms might exchange production schedules or details on the status of orders.
iii. At the collaboration level, information is not just exchanged and transmitted, but the buyer and seller also jointly develop it.
5. Design for manufacturability is a process that is part of the project management of a new product. It is concerned with finding optimal solutions to minimizing product failures and other adversities in the delivery of a new product to customers.
6. Simulation software is available to develop production systems that can enhance financial performance.
a. The software can be used to observe the important interactions and dependencies that exist in organizational systems and allow the testing of equipment reconfigurations, distribution channel changes, and quality enhancement programs.
b. Benefits from such simulations include greater and faster throughput, reduced inventory levels, reduced waste or spoilage, minimization of errors, and cost savings from reduced run time, setup time, or transportation time.
7. A focused factory arrangement is an arrangement in which a vendor agrees to provide a limited number of products according to specifications or to perform a limited number of unique services for a company that is typically operating on a just-in-time system.
a. A focused factory arrangement may involve relocation or plant modernization by the vendor, and financial assistance from the JIT manufacturer might be available to recover such investments.
b. The vendor benefits from long-term supply contracts.
c. Major reliance on a single customer can be difficult, especially for small companies.
H. Accounting Implications of JIT
1. Variance reporting and analysis in JIT systems virtually disappear since most variances first appear in a physical (rather than financial) fashion.
a. JIT requires that variances be recognized on the spot so that causes can be determined and, if possible, rapidly removed.
b. JIT workers are trained and expected to constantly oversee quality and efficiency while production occurs rather than just at the end of production.
c. Material price variances should be minimal due to long-term price agreements with vendors.
d. The ability to control material quality is provided by the ongoing use of specified vendors, so that little or no material usage variances should be caused by substandard materials.
e. The JIT system is stopped when defects are encountered; the error causing an unfavorable material usage variance is then corrected.
f. One usage variance type is caused by engineering changes (ENCs) made to product specifications. A JIT system has both an annual and a current comparison standard (design modifications would change the current standard but not the annual one).
i. The annual standard is one of the bases for the preparation and execution of the company¡¯s master budget and is ordinarily kept intact because all of the financial plans and arrangements for the year covered by the master budget are predicated on the standards and plans used to prepare the master budget.
ii. Such a procedure allows comparisons to be made that indicate the cost effects of ECOs implemented after a product has begun to be manufactured.
iii. Text Exhibit 18¨C11 illustrates the calculation of a material quantity variance caused by an ECO.
g. Labor variances should be minimal if standard rates and times have been appropriately set.
h. Direct labor and factory overhead costs should be recorded in a Conversion Costs account under JIT.
i. Companies adopting a JIT system should replace the raw material inventory classification with a Raw and In Process (RIP) Inventory account since materials would be acquired only when and as production occurs.
2. Backflush costing is a streamlined cost accounting method that speeds up, simplifies, and minimizes accounting effort in an environment that minimizes inventory balances, requires few allocations, uses standard costs, and has minimal variances from standard (See text Exhibit 18-12).
a. Fewer costs will need to be arbitrarily allocated to products since more costs can be traced directly to their related output in a JIT system.
b. Energy costs are charged directly to production in a comprehensive JIT system because there should be only minimum machine downtime or planned idle time for workers.
c. Inventory implementation of the JIT philosophy can result in substantial cost reductions and productivity improvements, but all inventory situations do not need to be on a JIT system.
d. Journal entries illustrating backflush costing are presented in the chapter narrative.
LO.6: What are flexible manufacturing systems?
3. Flexible Manufacturing Systems and Computer-Integrated Manufacturing
a. Many manufacturers have changed their manufacturing philosophy in the past few decades. Causes of change include (1) automated equipment, (2) a cellular plant layout, (3) computer hardware and software technology, and (4) new manufacturing systems and philosophies such as JIT and activity-based management.
b. A flexible manufacturing system (FMS) is a network of robots and material conveyance devices monitored and controlled by computers that allows for rapid production and prompt responsiveness to changes in production needs.
c. Computer-integrated manufacturing (CIM) is the integration of two or more FMSs through the use of a host computer and an information networking system.
d. Text Exhibit 18-13 contrasts the dimensions of a traditional manufacturing system with a flexible manufacturing system.
e. An FMS can operate in a ¡°lights-out¡± environment and never tire since the need for direct labor is minimal.
i. However, because workers perform a greater variety of tasks, workers in a company employing an FMS must be more highly trained than those working in traditional manufacturing environments.
ii. Managing manufacturing cells requires that workers have greater authority and responsibility because production and production scheduling changes happen so rapidly on the shop floor that an FMS relies on immediate decisions by persons who are on site and have a grasp of the underlying facts and conditions.
4. Lean Enterprises
a. Lean manufacturing refers to making only those items demanded by customers and making those items without waste.
b. Lean manufacturing originated in post-World War II Japan where managers of Japanese enterprises developed practices that minimized waste and consumption of resources.
c. The lean enterprise wields many of the management tools discussed earlier in this chapter such as cellular manufacturing, JIT, six sigma, TQM, and team-based production.
d. Central to the success of the lean enterprise and its value chain are leveraging technology and training employees.
e. Some of the performance benefits from implementing lean practices are shown in text Exhibit 18-14.
f. Lean enterprises have raised the competitive bar in many industries through their abilities to quickly develop and sell high-quality products having minimal defects. For some industries, these competitive pressures have led to reduced product life cycles and dramatically reduced time to market for new products.
Exhibit 18-15 describes life cycle costing using nanomanufacturing versus
traditional manufacturing methods.
LO.7: How can the theory of constraints help in determining production flow?
I. Theory of Constraints
1. The theory of constraints (TOC) is a method of analyzing the bottlenecks (constraints) that keep a system from achieving higher performance. TOC states that production cannot take place at a rate faster than the slowest machine or person in the process.
a. A constraint is anything that confines or limits the ability to perform a project or function.
b. A bottleneck is any object or facility whose processing level is sufficiently slow to cause the other processing mechanisms in its network to experience idle time.
will always exist, even in a totally automated process, because all machines do
not operate at the same speed nor do they handle the same capacity; therefore,
it is necessary to identify the constraints and work around them.
See text Exhibit 18¨C16 for a simplified illustration of a
constraint in a production process. Machine constraints also impact quality
Managers normally choose quality control points to follow the completion
of some particular process.
When constraint points are known, quality control points should
be placed in front of
If a part is scrapped after it¡¯s passed through the bottleneck, then time
has been lost that cannot be recovered.
As soon as constraints are known, a company should make the best use of
the time or productive capacity the constrained processes provide and limit the
constraints¡¯ impact on performance.
a. Options to reduce limitations, such as adding more machines to perform the constrained activity or processing material through other machines, should be investigated.
LO.8: (Appendix) How are economic order quantity, reorder point, and safety stock determined and used?
J. EOQ and Related Issues
1. Economic Order Quantity
a. The objective of the purchasing manager is to buy in the most economical quantity possible, which requires consideration of the inventory ordering and carrying costs.
b. The economic order quantity (EOQ) is an estimate of the number of units per order that will be the least costly and provide the optimal balance between the costs of ordering and the costs of carrying inventory. The EOQ is determined by the following formula:
where EOQ = economic order quantity in units
Q = estimated annual quantity used in units
O = estimated cost of placing one order
C = estimated cost to carry one unit in stock for one year
c. The EOQ formula does not include purchase cost since that amount relates to the decision of ¡°from whom to buy¡± rather than to ¡°how many to buy.¡±
d. EOQ is a tool that is used in conjunction with traditional ¡°push¡± production and inventory management systems.
i. Acquiring and holding inventory before it is needed is incompatible with ¡°pull¡± systems such as JIT.
e. Purchase cost must be viewed in relation to quality and reliability, and the supplier with the lowest cost is not necessarily the best supplier.
f. Purchase cost does not affect ordering and carrying costs, except to the extent that opportunity cost is calculated on the basis of investment.
g. The EOQ model assumes that orders will be filled exactly when needed, so that the inventory on hand will be zero units when an order arrives.
i. The average inventory is therefore EOQ / 2.
The number of
times an order must be placed depends on how many units are ordered each time,
and total number of orders equals
Total Annual Demand / EOQ
iii. The EOQ formula contains estimated values, but small cost estimation errors usually will not cause a major impact on total cost.
h. The costs of ordering and carrying inventory offset each other when estimating the economic order quantity.
i. Factors like cash availability and storage space constraints should be considered if the cost of ordering quantities close to the EOQ level is not significantly different from the cost of ordering at the EOQ level.
2. Economic Production Run
a. An economic production run (EPR) is an estimate that reflects the production quantity that minimizes the total costs of setting up a production run and carrying a unit in stock for one year.
b. The EPR formula is:
where EPR = economic production run quantity
Q = estimated annual quantity produced in units
S = estimated cost of setting up a production run
C = estimated cost of carrying one unit in stock for one year
c. The differences in costs among various run sizes around the EPR may not be significant, and if such costs are insignificant, management would have a range of acceptable economical production run quantities.
d. The critical element in using either an EOQ or EPR model is to properly identify costs, especially carrying costs.
i. Some costs (such as those for facilities, operations, administration, and accounting) traditionally viewed as irrelevant fixed costs should be considered long-term relevant variable costs.
e. The EOQ model does not provide any direction for managers attempting to control all of the separate costs that collectively compose ordering and carrying costs since the model treats the two costs as trade-offs.
3. Order Point of Safety Stock
a. The order point is the level of inventory that triggers the placement of an order for additional units; it is determined based on usage, lead time, and safety stock.
b. Usage refers to the quantity of inventory used or sold each day.
c. Lead time is the time it takes from the placement of an order to the time the goods arrive for usage or are produced by the company. The order point with lead time is calculated as:
Order Point = Daily Usage ¡Á Lead Time
d. Safety stock is the quantity of inventory kept on hand by a company in the event of fluctuating usage or unusual delays in lead time. When a safety stock is maintained, the order point formula is:
Order Point = (Daily Usage ¡Á Lead Time) + Safety Stock
i. A safety stock of inventory is carried to act as a buffer to protect the company against the possibility of stockouts.
ii. Safety stock size should be established based on how crucial the item is to production or to the retail business, the item¡¯s purchase cost, and the degree of uncertainty related to both usage and lead time.
4. Pareto Inventory Analysis
a. Pareto inventory analysis is a process of separating inventory items into three groups based on annual cost-to-volume usage; items that are of the highest value are referred to as A items (typically 20 percent of the inventory items, which constitute 80 percent of the cost), while C items (typically 50 percent of the items, representing 10 percent of the cost) represent the lowest dollar volume usage (See text Exhibit 18-17).
b. Management can determine the best inventory control method for each item once inventory is categorized as A, B, or C. For example, A-type inventory may require a perpetual inventory system and JIT purchasing techniques; C-type inventory may require a periodic inventory system and either a two-bin or a red-line system; while B-type inventory will require the type of system (perpetual or periodic) and the level of internal controls that management decides to be appropriate.
c. A two-bin system is an inventory ordering system in which two containers (or stacks) of raw materials or parts are available for use; when one container is depleted, the removal of materials from the second container begins and a purchase order is placed to refill the first container.
d. A red-line system is an inventory ordering system in which a red line is painted on the inventory container at a point deemed to be the reorder point.