Advanced Managerial Accounting

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ACT 5733 – Advanced Managerial Accounting

Chat # 8 – Inventory Management

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

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Chat Outline

  • Review HW
  • Inventory costs
  • Economic-order quantity model
  • Reorder point
  • Cost of prediction errors
  • JIT inventory

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

Costs of Inventory

  • Purchasing costs (including in-coming freight costs)
  • Ordering costs
  • Carrying costs
  • Stock-out costs
  • Costs of quality
  • Shrinkage costs

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

EOQ Decision Model

  • What size orders should we place to minimize the sum of ordering and carrying costs?
  • Assumes same amount ordered each time, demand, ordering costs, carrying costs, and lead time are known
  • Cost per unit unaffected by order size
  • No stock-outs occur

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

EOQ Formula

  • EOQ = SQRT (2 x D x P / C)
  • D = demand for period of time
  • P = Relevant costs per purchase order
  • C = Relevant carrying costs per unit
  • Average inventory is EOQ / 2
  • Relevant carrying costs = (EOQ / 2) x C
  • # of orders = D / EOQ
  • Relevant ordering costs = (D / EOQ) x P

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

EOQ Example

ACT 5733 - Chat 8 - Felo

Annual Demand 52,000 units
Carrying costs (including ROI on capital) $2.60 per unit
Costs per purchase $400
Lead time (weeks) 1
EOQ 4,000 units
# of orders to be placed 13 orders
Total ordering costs $5,200
Total carrying costs $5,200

ACT 5733 - Chat 8 - Felo

When to Order Inventory?

  • With certainty – Units sold per period x Order lead time
  • 1,000 units per week x 1 week lead = 1,000 units
  • With uncertainty – safety stock should be considered
  • Safety stock should minimize sum of carrying and stock-out costs

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

Cost of Prediction Error

  • Compare cost of “optimal” decision with cost of decision made with incorrect data
  • The magnitude of this can help management determine whether it makes sense to seek out “better” information

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

Prediction Error Example - 1

ACT 5733 - Chat 8 - Felo

Annual Demand 52,000 units
Carrying costs (including ROI on capital) $2.60 per unit
Actual costs per purchase $400
Expected costs per purchase $200
Lead time (weeks) 1
Expected EOQ 2,829 units
# of orders to be placed 19 orders
Total ordering costs $7,600
Total carrying costs $3,678
Total cost with correct information $10,400
Prediction error $878 (8%)

ACT 5733 - Chat 8 - Felo

Prediction Error Example - 2

ACT 5733 - Chat 8 - Felo

Annual Demand 52,000 units
Carrying costs (including ROI on capital) $2.60 per unit
Actual costs per purchase $400
Expected costs per purchase $100
Lead time (weeks) 1
Expected EOQ 2,000 units
# of orders to be placed 26 orders
Total ordering costs $10,400
Total carrying costs $2,600
Total cost with correct information $10,400
Prediction error $2,600 (25%)

ACT 5733 - Chat 8 - Felo

Just-In Time Inventory

  • Attempt to acquire inventory (purchase or produce) “just in time” to be used
  • “Demand pull” system
  • Focus is on carrying costs
  • Also can help identify inefficiencies in operations and flaws in forecasts
  • Requires cooperation through supply chain (suppliers and customers)

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

Metrics for JIT

  • Track information on internal performance & supplier reliability
  • On-time delivery %
  • Cycle time
  • Defect rates or % yield
  • Unscheduled downtime
  • Sales increase from JIT implementation
  • Customer satisfaction
  • # of rush shipments required

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo

Other Metrics for JIT

  • Track information on internal performance & supplier reliability
  • % of supplier shipments without defects / errors
  • Cost of ownership
  • % of supplier shipments on time
  • Delays (time lost) due to supplier errors

ACT 5733 - Chat 8 - Felo

ACT 5733 - Chat 8 - Felo