CHAPTER 20INVENTORY MANAGEMENT, JUST-IN-TIME,

AND BACKFLUSH COSTING

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 76.8%, and net income to sales is 1.4%. Thus, a 10% reduction in the ratio of cost of goods sold to sales (76.8 to 69.1%) without any other changes can result in a 550% increase in net income to sales (1.4% to 9.1%).

20-2 Five cost categories important in managing goods for sale in a retail organization are:1. Purchasing costs2. Ordering costs3. Carrying costs4. Stockout costs5. Quality costs

20-3 Five assumptions made when using the simplest version of the EOQ model are:1. The same fixed quantity is ordered at each reorder point.2. Demand, ordering costs, carrying costs, and the purchase-order lead time are certain.3. Purchasing costs per unit are unaffected by the quantity ordered.4. No stockouts occur.5. Costs of quality are considered only to the extent that these costs are components of

ordering costs or carrying costs.

20-4 Costs included in the carrying costs of inventory are incremental costs for such items as insurance, rent, obsolescence, spoilage, and breakage 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:1. The return forgone by investing capital in inventory,2. Lost contribution margin on existing sales when a stockout occurs, and3. 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.

20-1

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 goods or materials such that a delivery immediately precedes demand or use. Benefits include lower inventory holdings (reduced warehouse space required and less money tied up in inventory) and less risk of inventory obsolescence and spoilage.

20-9 Factors causing reductions in the cost to place purchase orders of materials are: Companies are establishing long-run purchasing arrangements in which price and

quality dimensions that apply over an extended period are agreed to by both parties. Companies are using electronic links, such as the internet, to place purchase orders. Companies are increasing the use of purchase-order cards.

20-10 The sequence of activities involved in placing a purchase order can be facilitated by use of the Internet by having online a complete price list, information about expected shipment dates, and a service order capability that is available 24 hours a day with email or fax confirmation. The cost of placing orders on the Internet is lower than placing orders by telephone or mail.

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 product to consumers, regardless of whether those activities occur in the same organization or in other organizations. Sharing of information across companies enables a reduction in inventory levels at all stages, fewer stockouts at the retail level, reduced manufacture of product not subsequently demanded by retailers, and a reduction in expedited manufacturing orders.

20-12 Obstacles to companies adopting a supply-chain approach include: Communication obstacles—the unwillingness of some parties to share information. Trust obstacles—includes the concern that all parties will not meet their agreed-upon

commitments. Information system obstacles—includes problems due to the information systems of

different parties not being technically compatible. Limited resources—includes problems due to the people and financial resources

given to support a supply chain initiative not being adequate.

20-13 Just-in-time (JIT) production is a “demand-pull” manufacturing system that has the following features:

Organize production in manufacturing cells, Hire and retain workers who are multiskilled, Aggressively pursue total quality management (TQM) to eliminate defects, Place emphasis on reducing both setup time and manufacturing lead time, and Carefully select suppliers who are capable of delivering quality materials in a timely

manner.

20-2

20-14 Traditional normal and standard costing systems use sequential tracking, which is any product-costing method where recording of the journal entries occurs in the same order as actual purchases and progress in production.

Backflush costing omits the recording of some or all of the journal entries relating to the cycle from purchase of direct materials to sale of finished goods. 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.

20-15 Versions of backflush costing differ in the number and placement of trigger points at which journal entries are made in the accounting system:

Number ofJournal EntryTrigger Points

Location in Cycle WhereJournal Entries Made

Version 1 3 Stage A. Purchase of direct materials Stage C. Completion of good finished units of productStage D. Sale of finished goods

Version 2 2 Stage A. Purchase of direct materials Stage D. Sale of finished goods

Version 3 2 Stage C. Completion of good finished units of productStage D. Sale of finished goods

20-3

20-16 (20 min.) Economic order quantity for retailer.

1. D = 10,000, P = $225, C = $10

= 670.82

671 jerseys

2. Number of orders per year = =

= 14.90 15 orders

3. =

=

= 27.40 jerseys per day Purchase lead time = 7 days

Reorder point = 27.40 7

= 191.80 192 jerseys

20-4

20-17 (20 min.) Economic order quantity, effect of parameter changes (continuation of 20-16).

1. D = 10,000, P = $20, C = $10

= 200 jerseys

The sizable reduction in ordering cost (from $225 to $20 per purchase order) has reduced the EOQ from 671 to 200.

2. The AP proposal has both upsides and downsides. The upside is potentially higher sales. FW customers may purchase more online than if they have to physically visit a store. FW would also have lower administrative costs and lower inventory holding costs with the proposal.

The downside is that AP could capture FW’s customers. Repeat customers to the AP Web site need not be classified as FW customers. FW 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 FW should accept AP’s proposal. Much depends on whether FW views AP as a credible, “honest” partner.

20-18 (15 min.) EOQ for a retailer.

1. D = 20,000, P = $160, C = 20% $8 = $1.60

EOQ = = = 2,000 yards

2. Number of orders per year: = = 10 orders

3. Demand each working day = = = 80 yards per day= 400 yards per week

Purchasing lead time = 2 weeksReorder point = 400 2 = 800 yards

20-5

20-19 (20 min.) EOQ for manufacturer.

1. Relevant carrying costs per part per year:Required annual return on investment 12% 50 = $6Relevant insurance, materials handling, breakage, etc. costs per year 2Relevant carrying costs per part per year $8

With D = 12,000; P = $120; C = $8, EOQ for manufacturer is:= = 600 units

2. = +

= +

= $2,400 + $2,400 = $4,800where Q = 600 units, the quantity ordered.

3. Purchase order lead time is half a monthMonthly demand is 12,000 units ÷ 12 months = 1,000 units per month.Demand in half a month is 1,000 units or 500 units.

Hence, Beaumont should reorder when inventory of CU29 falls to 500 units.

Excel 20-19Inventory Management, JIT, and Backflush CostingBeaumont Corporation

Original Data

Annual demand 12,000 unitsPurchase cost per unit $50 Required return on investment 12%Relevant ordering costs per purchase order $120

Relevant carrying cost per unit per year:Required annual return on investment $6 per unitRelevant insurance, materials handling,and breakage per year $2 per unitTotal carrying cost per unit per year $8 per unit

Problem 1

D 12,000 P $120 C $8

Economic order quantity 600 units

20-6

20-19 (Cont’d.)

Problem 2

Annual relevant ordering costs $2,400 Annual relevant carrying costs $2,400 Relevant total costs $4,800 per year

Problem 3

Monthly demand 1,000 unitsPurchasing lead time 0.5 monthReorder point 500 units

20-20 (20 min.) Sensitivity of EOQ to changes in relevant ordering and carrying costs.

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 =

where D = demand in units for a specified period of time

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 CarryingCosts Per Unit Relevant Ordering Costs Per Purchase Order

Per Year $300 $200

$10 = 775= 632

15 = 632= 516

20 = 548= 447

2. For a given demand level, as relevant carrying costs increase, EOQ becomes smaller. For a given demand level, as relevant order costs increase, EOQ increases.

20-7

20-21 (20-30 min.) Purchase-order size for retailer, EOQ, just-in-time purchasing.

1. EOQ = a. D = 6,000; P = $30; C = $1

EOQ = = = 600 cases

b. D = 6,000; P = $30; C = $1.50

EOQ = = = 489.9 cases –490 cases

c. D = 6,000; P = $5; C = $1.50

EOQ = = = 200 cases

2. A just-in-time purchasing policy involves the purchase of goods or materials such that their delivery immediately precedes their demand or use. Given the purchase order sizes calculated in requirement 1, the number of purchase orders placed each month is (D ÷ EOQ):

a. = = 10 orders per month or –1 every 3 days

b. = = 12.25 orders per month or –1 every 2.45 days

c. = = 30 orders per month or –1 every day

An increase in C and a decrease in P lead to increases in the optimal frequency of orders. The 24-Hour Mart has increased the frequency of delivery from every third day (1a: P = $30; C = $1) to a delivery every day (1c: P = $5; C = $1.50). There is a reduction of 200 cases in the average inventory level: (600 – 200) ÷ 2 = 200.

20-8

20-22 (20 min.) JIT production, relevant benefits, relevant costs.

1. Solution Exhibit 20-22 presents the annual net benefit of $154,000 to Evans Corporation of implementing a JIT production system.

2. Other nonfinancial and qualitative factors that Evans 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.

SOLUTION EXHIBIT 20-22Annual Relevant Costs of Current Production System and JIT Production Systemfor Evans Corporation

Relevant Items

Relevant Costs under

Current Production

System

RelevantCosts under

JITProduction

System Annual tooling costs – $150,000Required return on investment:12% per year $900,000 of average inventory per year $108,00012% per year $200,000 of average inventory per year 24,000

Insurance, space, materials handling, and setup costs 200,000 140,000a

Rework costs 350,000 280,000b

Incremental revenues from higher selling prices – (90,000 )c

Total net incremental costs $658,000 $504,000 Annual difference in favor of JIT production $154,000

a$200,000 (1 – 0.30) = $140,000b$350,000 (1 – 0.20) = $280,000c$3 × 30,000 units = $90,000

20-9

20-22 (Cont’d.)

3a. 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 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:

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:

Cost of rework Ordering costs Stockout costs Inventory turnover

3b. 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 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.

20-23 (30 min.) Backflush costing and JIT production.

1.

(a) Purchases of direct materials Inventory: Direct and In-Process Control 2,754,000 Accounts Payable Control 2,754,000

(b) Incur conversion costs Conversion Costs Control 723,600 Various Accounts 723,600

(c) Completion of finished goods Finished Goods Controla 3,484,000 Inventory: Direct and In-Process Control 2,733,600 Conversion Costs Allocated 750,400

(d) Sale of finished goods Cost of Goods Soldb 3,432,000 Finished Goods Control 3,432,000

a. 26,800 × ($102 + $28) = $3,484,000b. 26,400 × ($102 + $28) = $3,432,000

20-10

20-23 (Cont’d.)

2. Inventory:

3. Under an ideal JIT production system, there could be zero inventories at the end of each day. Entry (c) would be $3,432,000 finished goods production, not $3,484,000. Also, there would be no inventory of direct materials instead of $2,754,000 – $2,733,600 = $20,400

20-11

Finished GoodsControl Cost of Goods SoldDirect and In-Process Control

(b) 723,600

Conversion Costs Control

(c) 750,400

Conversion Costs Allocated

(d) 3,432,000(d) 3,432,000(c) 3,484,000

Bal. 20,400

(a) 2,754,000(c) 2,733,600

Bal. 52,000

Conversion Costs

Direct Materials

20-24 (20 min.) Backflush costing, two trigger points, materials purchase and sale (continuation of 20-23).

1.(a) Purchases of direct materials Inventory Control 2,754,000

Accounts Payable Control 2,754,000(b) Incur conversion costs Conversion Costs Control 723,600

Various Accounts 723,600(c) Completion of finished goods No entry

(d) Sale of finished goods Cost of Goods Sold 3,432,000 Inventory Control 2,692,800 Conversion Costs Allocated 739,200

(e) Underallocated or Conversion Costs Allocated 739,200 Overallocated conversion Costs of Goods Sold 15,600 Costs Conversion Costs Control 723,600

2.

20-12

(e) 15,600(d) 3,432,000

Cost of Goods Sold Inventory Control

(d) 2,692,800(a) 2,754,000

Bal. 61,200

(d) 739,200

Conversion Costs Allocated

(e) 739,200

Conversion Costs Control

(b) 723,600 (e) 723,600

Conversion Costs

Direct Materials

20-25 (20 min.) Backflush costing, two trigger points, completion of production and sale (continuation of 20-23 and 20-24).

(a) Purchases of direct materials No Entry(b) Incur conversion costs Conversion Costs Control 723,600

Various Accounts 723,600(c) Completion of finished goods Finished Goods Control 3,484,000

Accounts Payable Control 2,733,600 Conversion Costs Allocated 750,400

(d) Sale of finished goods Cost of Goods Sold 3,432,000 Finished Goods Control 3,432,000

(e) Underallocated or Conversion Costs Allocated 750,400 Overallocated conversion Costs of Goods Sold 26,800 Costs Conversion Costs Control 723,600

20-13

(c) 750,400

Conversion Costs Allocated

(e) 750,400

(b) 723,600

Conversion Costs Control

(e) 723,600

(d) 3,432,000 (e) 26,800

Cost of Goods Sold

(c) 3,484,000

Finished Goods Control

(d) 3,432,000

Bal. 52,000

Conversion Costs

Direct Materials

20-26 (30 min.) Effect of different order quantities on ordering costs and carrying costs, EOQ.

1. A straightforward approach to this requirement is to construct the following table for different purchase-order quantities.

D: Demand 26,000 26,000 26,000 26,000 26,000

Q: Order quantity 300 500 600 700 900

Q/2: Average inventory in units 150 250 300 350 450

D/Q: Number of purchase orders 86.67 52 43.33 37.14 28.89

(D/Q) P: Annual ordering costs $6,240 $3,744 $3,120 $2,674 $2,080

(Q/2) C: Annual carrying costs 1,560 2,600 3,120 3,640 4,680Total relevant costs of ordering and carrying inventory $7,800 $6,344 $6,240 $6,314 $6,760

MinimumCost

D = 26,000 unitsQ = order quantityP = $72C = $10.40

EOQ = = = = 600 packages

The shape of the total relevant cost function for Koala Blue is relatively flat from order quantities 500 to 700.

2. When the ordering cost per purchase order is reduced to $40:

EOQ = = = 447.2 packages or 447 packages (rounded)

The EOQ drops from 600 packages to 447 packages when Koala Blue's ordering cost per purchase order drops from $72 to $40.

20-14

20-27 (30–45 min.) EOQ, uncertainty, safety stock, reorder point (CMA, adapted).

1. The Starr Company is searching for the safety stock level that will minimize the expected total of the costs of carrying additional inventory and the costs associated with insufficient inventories (stockout costs). The present reorder point, alternative safety stock levels, and probability of usage during lead time have to be computed before this level can be determined.

The present reorder point is calculated as follows:

Average daily usage =

= = 100 units per day

Reorder point = Average daily usage Lead time

= (100 units per day) 5 days = 500 units

Alternative safety stock levels would be the number of units needed to cover possible demand levels during lead time. These safety levels can be determined as follows:

Possible safety stock levels = Possible demand – Reorder point

The alternative safety stock levels are 0, 20, 40, and 60 units. The probability of demand during lead time is:

Demand DuringLead Time

Number ofTimes QuantityWas Demanded Probability

440 6 0.03460 12 0.06480 16 0.08500 130 0.65520 20 0.10540 10 0.05560 6 0 .03

200 1 .00

20-15

20-27 (Cont'd.)

SafetyStockLevel

in Units(1)

DemandRealizations

Resultingin Stockouts

(2)

Stockout

in Unitsa

(3)=(2) –500 – (1)

Probabilityof

Stockout(4)

RelevantStockout

Costsb

(5)=(3) $20

Number of Orders

Per Yearc

(6)

ExpectedStockout

Costsd

(7)=(4) (5)

(6)

RelevantCarrying

Costse

(8)=(1) $10

TotalRelevant

Costs(9)=(7)+(8)

0

20

40

60

520540560

540560

560

––

204060

2040

20

––

0.100.050.03

0.050.03

0.03

––

$ 400800

1,200

400800

400

––

101010

1010

10

––

$ 400400

360 $1,160

$ 200 240 $ 440

$ 120

$ 0 f

$ 0

$200

$400

$600

$1,160

$ 640

$ 520

$ 600

a Realized demand – inventory available during lead time (excluding safety stock), 500 units – safety stock.b Stockout units relevant stockout costs of $20 per motor.c Annual demand 30,000 ÷ 3,000 EOQ = 10 orders per year.d Probability of stockout relevant stockout costs number of orders per year.e Safety stock annual relevant carrying costs of $10 per motor (assumes that safety stock is on hand at all times

and that there is no overstocking caused by decreases in expected usage).f At a safety stock level of 60 motors, no stockouts will occur and, hence, expected stockout costs = $0.

Safety stock of 40 units would minimize Starr Company's total expected stockout and carrying costs.

2. The new reorder point would be:

Present reorder point (demand during lead time: 100 5) 500 unitsSafety stock 40 unitsNew reorder point 540 units

20-16

20-27 (Cont'd.)

3. The factors Starr Company should have considered when estimating the stockout costs include:

a. Possible lost contribution margin on motors not sold.b. Costs associated with disruption or idle time.c. Forgone contribution margin on future sales from possible loss of customers and

customer goodwill.d. Additional clerical costs involved in keeping records of back orders.e. How valid is the past empirical distribution of demand when predicting the future

demand distribution?f. Additional order costs and transportation costs.

20-28 (20–30 min.) EOQ, cost of prediction error.

1. EOQ = D = 2,000; P = $40; C = $4 + (10% $50) = $9

EOQ = = 133.333 tires –133 tires (approximately)

TRC = + where Q can be any quantity, including the EOQ

= + = $600 + $600 = $1,200

If students used an EOQ of 133 tires (order quantities rounded to the nearest whole number),

TRC = + = $601.5 + $598.5 = $1,200.

Sum of annual relevant ordering and carrying costs equals $1,200.

2. The prediction error affects C, which is now:

C = $4 + (10% $30) = $7

D = 2,000, P = $40, C = $7

EOQ = = 151.186 tires = 151 tires (rounded)

20-17

20-28 (Cont'd.)

The cost of the prediction error can be calculated using a three-step procedure:

Step 1: Compute the monetary outcome from the best action that could have been taken, given the actual amount of the cost input.

TRC = +

= +

= $529.15 + $529.15 = $1,058.30

Step 2: Compute the monetary outcome from the best action based on the incorrect amount of the predicted cost input.

TRC = +

= +

= $600 + $466.67 = $1,066.67

Step 3: Compute the difference between the monetary outcomes from Step 1 and Step 2:

Monetary OutcomeStep 1 $1,058.30Step 2 1,066 .67 Difference $ (8 .37 )

The cost of the prediction error is $8.37.

Note: The $20 prediction error for the purchase price of the heavy-duty tires is irrelevant in computing purchase costs under the two alternatives because the same purchase costs will be incurred whatever the order size.

Some students may prefer to round off the EOQs to 133 tires and 151 tires, respectively. The calculations under each step in this case follow:

Step 1: TRC = + = $529.80 + $528.50 = $1058.30

Step 2: TRC = + = $601.50 + $465.50 = $1067.00

Step 3: Difference = $1,058.30 – $1,067.00 = ($8.70)

20-18

20-29 (30 min.) JIT purchasing, relevant benefits, relevant costs (CMA, adapted).

1. Solution Exhibit 20-29 presents the $37,500 cash savings that would result if Margro Corporation adopted the just-in-time inventory system in 2000.

2. Conditions that should exist in order for a company to install "just-in-time" inventory successfully include the following:

• Top management must be committed and provide the necessary leadership support in order to ensure a companywide, coordinated effort.

• A detailed system for integrating the sequential operations of the manufacturing process needs to be developed and implemented. Direct materials must arrive when needed for each subassembly so that the production process functions smoothly.

• Accurate sales forecasts are needed for effective finished goods planning and production scheduling.

• Products should be designed to use standardized parts to reduce manufacturing time and reduce costs.

• Reliable vendors who can deliver quality direct materials on time with minimum lead time must be obtained.

20-19

20-29 (Cont'd.)

SOLUTION EXHIBIT 20-29Annual Relevant Costs of Current Purchasing Policy and JIT Purchasing Policyfor Margro Corporation

Relevant Costs under

Current Purchasing

Policy

RelevantCosts under

JITPurchasing

Policy Required return on investment 20% per year x $600,000 of average inventory per year $120,000 20% per year x $0 inventory per year $ 0Annual insurance costs 14,000 0

Warehouse rent 60,000 (13,500)a

Overtime costs No overtime 0 Overtime premium 40,000Stockout costs No stockouts 0

$6.50b contribution margin per unit x 20,000 units 130,000Total incremental costs $194,000 $156,500Difference in favor of JIT purchasing $37,500

a $(13,500) = Warehouse rental revenues, [(75% x 12,000) x $1.50].bCalculation of unit contribution margin

Selling price($10,800,000 ÷ 900,000 units) $12.00

Variable costs per unit :Variable manufacturing costs per unit

($4,050,000 ÷ 900,000 units) $4.50Variable marketing and distribution costs per unit

($900,000 ÷ 900,000 units) 1.00Total variable costs per unit 5.50

Contribution margin per unit $ 6.50

Note that the incremental costs of $40,000 for overtime premiums to make the additional 15,000 units are less than the contribution margin from losing these sales equal to $97,500 ($6.50 x 15,000). Margro would rather incur overtime than lose 15,000 units of sales.

20-20

20-30 (25 min.) Relevant benefits and relevant costs of JIT purchasing.

Solution Exhibit 20-30 presents the $724.50 cash savings that would result if Hardesty Medical Instruments adopted the Just-in-time inventory system in 2003.

SOLUTION EXHIBIT 20-30

Annual Relevant Costs of Current Purchasing Policy and JIT Purchasing Policy for Hardesty Medical Instruments

Relevant Costs Under Current JIT

Purchasing Purchasing Relevant Item Policy Policy Purchasing costs

$10 per unit 20,000 units $200,000.00$10.05 per unit × 20,000 units $201,000.00

Ordering costs$5 per order × 20 orders per year 100.00$5 per order × 200 orders per year 1,000.00

Opportunity carrying costs, requiredreturn on investment20% per year × $10 cost per unit × 500a

units of average inventory per year 1,000.0020% per year × $10.05 cost per unit× 50b units of average inventory per year 100.50

Other carrying costs$4.50 per unit per year × 500a unitsof average inventory per year 2,250.00$4.50 per unit per year × 50b unitsof average inventory per year 225.00

Stockout costsNo stockouts 0$3 per unit × 100 units per year 300.00

Total annual relevant costs $203,350.00 $202,625.50

Annual difference in favor of JIT purchasing $724.50a Order quantity ÷ 2 = 1,000 ÷ 2 = 500b Order quantity ÷ 2 = 100 ÷ 2 = 50

2. Hardesty may benefit from Morrison managing its inventories if there is high order variability caused by randomness in when consumers purchase surgical scalpels or trade promotions that prompt retailers to stock for the future. By coordinating their activities and sharing information about retail sales and inventory held throughout the supply chain, Morrison can plan its manufacturing activities to ensure adequate supply of product while keeping inventory low. For this to succeed, Hardesty and Morrison must have compatible information systems, build trust, and communicate freely.

20-21

20-31 (30 min.)Supplier evaluation and relevant costs of quality and timely deliveries (continuation of 20-30).

Solution Exhibit 20-31 shows that annual relevant purchasing costs are $9,692 lower if purchases are made from Morrison instead of Herriott. Hardesty should buy XJ-200 from Morrison.

SOLUTION EXHIBIT 20-31Annual Relevant Costs of Purchasing from Morrison and Herriott

Relevant Costs of Purchasing from Relevant Item Morrison Herriott Purchasing costs

$10.05 per unit × 20,000 units per year $201,000.00$ 9.75 per unit × 20,000 units per year $195,000.00

Ordering costs$5 per order × 200 orders per year 1,000.00$5 per order × 200 orders per year 1,000.00

Inspection costsNo inspection necessary 0$0.08 per unit × 20,000 units 1,600.00

Opportunity carrying costs, required returnon investment 20% per year × $10.05 cost per unit × 50a units of average inventory per year 100.5020% per year × $9.75 cost perunit × 50a units of averageinventory per year 97.50

Other carrying costs$4.50 per unit per year × 50a unitsof average inventory per year 225.00$4.40 per unit per year × 50a unitsof average inventory per year 220.00

Stockout costs$3 per unit × 100 units per year 300.00$3 per unit × 800 units per year 2,400.00

Customer returns costsNo customer returns 0$6 per unit returned × 10% × 20,000 units 12,000.00

Total annual relevant costs $202,625.50 $212,317.50

Annual difference in favor of Morrison $9,692

a Order quantity ÷ 2 = 100 ÷ 2 = 50

20-22

20-32 (25 min.) Supplier evaluation and relevant costs of quality and timely deliveries.

Solution Exhibit 20-32 presents the $1,450 annual relevant costs difference in favor of purchasing from Quality Sports. Copeland should buy the footballs from Quality Sports.

SOLUTION EXHIBIT 20-32Annual Relevant Costs of Purchasing from Big Red and Quality Sports

Relevant Costs of Purchasing from Relevant Item Big Red Quality Sports Purchasing costs

$ 50 per unit × 12,000 units per year $600,000$ 51 per unit × 12,000 units per year $612,000

Ordering costs$6 per order × 60a orders per year 360$6 per order × 60a orders per year 360

Inspection costs$0.02 per unit × 12,000 units 240No inspection necessary 0

Opportunity carrying costs, required returnon investment, 15% per year × $50 cost per unit × 100 units of average inventory per year; 75015% per year × $51 cost perunit × 100 units of averageinventory per year 765

Other carrying costs (insurance, materialhandling, and so on)$4 per unit × 100 units of averageinventory per year 400$4.50 per unit × 100 units of averageinventory per year 450

Stockout costs$20 per unit × 350 units per year 7,000$10 per unit × 60 units per year 600

Customer returns costs$25 per unit × 300 units 7,500$25 per unit × 25 units 625

Total annual relevant costs $616,250 $614,800

Annual difference in favor of Quality Sports $1,450

a Number of orders placed:Average inventory per year 100 units

Average order size = 100 × 2 = 200 units Annual demand = 12,000 units Number of orders placed = 12,000 units/200 units per order = 60 orders

20-23

20-33 (20 min.) Blackflush costing and JIT production.

1.

(a) Purchases of direct materials Inventory: Direct and In-Process Control 550000 Accounts Payable Control 550000

(b) Incur conversion costs Conversion Costs Control 440000 Various Accounts 440000

(c) Completion of finished goods Finished Goods Controla 945000 Inventory: Direct & In-Process Control 525000 Conversion Costs Allocated 420000

(d) Sale of finished goods Cost of Goods Soldb 900000 Finished Goods Control 900000

a 21000 × $45 ($25 + $20) = $945000

b 20000 × $45 = $900000

2.

20-24

20-34 (20 min.) Backflush, two trigger points, materials purchase and sale (continuation of 20-32).

1.

(a) Purchases of direct materials Inventory Control 550,000Accounts Payable Control 550,000

(b) Incur conversion costs Conversion Costs Control 440,000Various Accounts (such as Accounts Payable

Control and Wages Payable) 440,000

(c) Completion of finished No entry goods

(d) Sale of finished goods Cost of Goods Sold 900,000Inventory Control 500,000Conversion Costs Allocated 400,000

(e) Underallocated Conversion Costs Allocated 400,000or overallocated Cost of Goods Sold 40,000conversion costs Conversion Costs Control 440,000

2.

20-25

(d) 900000

(b) 440000 (e) 440000

ConversionCosts

Inventory Control

Conversion Costs Allocated

Conversion Costs Control

Cost of Goods Sold

(a) 550000 (d) 500000

(e) 400000 (d) 400000

Bal.50000

(e) 40000

Direct Materials

20-35 (20 min.) Backflush, two trigger points, completion of production and sale (continuation of 20-31 and 20-32).

1.(a) Purchase of direct materials No entry

(b) Incur conversion costs Conversion Costs Control 440,000Various Accounts (such as Accounts Payable Control and Wages Payable) 440,000

(c) Completion of finished Finished Goods Control 945,000

goods Accounts Payable Control 525,000Conversion Costs Allocated 420,000

(d) Sale of finished goods Cost of Goods Sold 900,000

Finished Goods Control 900,000

(e) Underallocated Conversion Costs Allocated 420,000or overallocated Cost of Goods Sold 20,000conversion costs Conversion Costs Control 440,000

2.

20-26

20-36 (30 min.) Backflush costing, income manipulation, ethics.

1. Factors SVC should consider in deciding whether to adopt a version of backflush costing include:

a. Effects on decision making by managers. There is a loss of information with backflushing. Supporters of backflushing maintain, however, that nonfinancial information and observation of production provide sufficient inputs to monitor production and management costs at the shop-floor level.

b. Costs of maintaining sequential tracking vis-à-vis backflush costing.c. Materiality of the differences. If the production lead time is short (say, less than one

day) and inventory levels are minimal (as one would anticipate with JIT), the differences between sequential tracking and backflush may be minimal.

d. Opportunity for managers to manipulate reported numbers.

2. Strong’s concerns certainly warrant consideration. Much depends on the corporate culture at SVC. If the culture is that quarterly or monthly reported numbers are pivotal to evaluations, and that managers “push the accounting system to facilitate meeting the numbers,” Strong should raise these issues with Brown. Adopting an accounting system with an obvious opportunity for manipulation (backflush with sale as the trigger point) may well send managers the wrong message.

Strong’s concerns, however are not by themselves sufficient to cause SVC to not adopt backflush costing. The factors mentioned in requirement 1 may well be compelling enough to support adoption of backflush costing. Brown has alternative ways to address Strong’s quite legitimate concerns—see requirement 3.

3. Ways to motivate managers to not “artificially change” reported income include:a. Adopting long-term measures that reduce the importance of short-run financial targets.b. Increasing the weight on nonaccounting-based variables—e.g., more use of stock options

or customer-satisfaction measures.c. Penalize heavily (the “stick approach”) managers who are found out to have “artificially

changed” reported income. This can include withdrawal of bonuses or even termination of employment.

20-27

20-37 (35–40 min.) Backflushing.

1. Glendale has successfully implemented JIT in its production operations and, hence, minimized work-in-process inventory. It still has a fair amount of raw material and finished goods inventory. Glendale should, therefore, adopt a backflush costing system with two trigger points, as follows:

a. Direct materials purchases charged to Inventory: Materials and In-Process Controlb. Completion of finished goods recorded as Finished Goods Control

The backflush approach described closely approximates the costs computed using sequential tracking. There is no work in process so there is no need for a Work in Process inventory account.

Further, by maintaining a Materials and In-Process Inventory Control and Finished Goods Control account, Glendale can keep track of and control the inventories of direct materials and finished goods in its plant.

2a. Glendale should adopt a backflush costing system with trigger points at completion of finished goods and at the sale of finished goods. This would approximate the sequential tracking approach since the question assumes Glendale has no direct materials or work-in-process inventories. There is, therefore, no need for these inventory accounts.

b. A backflush costing system with two trigger points—when purchases of direct materials are made (debited to Inventory Control), and when Finished Goods are sold—would approximate sequential tracking, since the question assumes Glendale has no work-in-process or finished goods inventories. c. A backflush costing system with a single trigger point when finished goods are sold would approximate sequential tracking, since the question assumes Glendale has no direct material, work-in-process or finished goods inventories. This is a further simplification of the three examples in the text.

The principle here is that backflushing of costs should be triggered at the finished goods inventory stage if Glendale plans to hold finished goods inventory. If Glendale plans to hold no finished goods inventory, backflushing can be postponed till the finished goods are sold. In other words, the trigger points for backflushing relate to the points where inventory is being accumulated. As a result, backflushing matches the sequential tracking approach and also maintains a record for the monitoring and control of the inventory.

3. Some comments on the quotation follow:a. The backflush system is a standard costing system, not an actual costing system.b. If standard costing is used, an up-to-date realistic set of standard costs is always desirable––as long as the set meets the cost-benefit test of updating.c. The operating environments of "the present JIT era" have induced many companies toward more simplicity (backflush) and abandoning the typical standard costing system (sequential tracking).d. Backflush is probably closer to being a periodic system than a perpetual system. However, a periodic system may be cost-effective, particularly where physical inventories are relatively low or stable.e. The textbook points out that, to be attractive, backflush costing should generate the same financial measurements as sequential tracking––and at a lower accounting cost.

20-28

20-37 (Cont’d.)

f. The choice of a product costing system is highly contextual. Its characteristics should be heavily affected by its costs, the preferences of operating managers, and the underlying operating processes. Sweeping generalizations about any cost accounting system or technique are unjustified.

Chapter 20 Internet ExerciseThe Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11 th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below.

The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter.

Internet Exercise

Although accountants include inventory on the balance sheet as an asset, one might argue that it's a liability. Jon Schreibfeder, of Inventory Management Inc., presents a series of articles discussing inventory management issues. Go to http://www.effectiveinventory.com/articles.html to access a list of recent articles on this topic.

1. Click on the link, “There's No Such Thing as Free Inventory.” Although vendors often offer full credit for unsold merchandise, carrying unsold inventory involves significant costs. What are some of these costs?

2a. Click on the link, "Are You Making Money?" Why is gross margin a poor measure of a product's contribution to overall profitability?

2b. What adjustment can you make to gross margin to obtain a better measure of their products’ true profitability?

2c. Use the following information to calculate the gross margin and the adjusted gross margin for products A and B.

Product A:Annual SalesCost of Goods SoldAverage Inventory ValueCarrying Cost

$20,000$14,000$10,000

20%

Product B:Annual SalesCost of Goods SoldAverage Inventory ValueCarrying Cost

$20,000$15,000$ 4,000

20%

20-29

Internet Exercise (Cont’d.)

2d. Which product has a higher gross margin? Which product has a higher adjusted gross margin?

3a. Click on "Calculating Your Target Inventory Investment.” If annual sales are $10 million, the gross margin is 40%, and projected inventory turnover is 5 times a year, what is the projected inventory investment?

3b. By what amount can we reduce our projected inventory investment if we can increase inventory turnover to 5.5 times a year?

4. Click on the link, “Implementing Effective Inventory Management.” What are the 14 characteristics of good inventory management?

Solution to Internet Exercise1. Inventory carrying costs include:

The cost of receiving merchandise, transporting it to shelves, and returning it to warehouse locations for storage.

Insurance on the inventory. Rent and utilities on the warehouse space used to store the inventory. The cost of counting and tracking inventory. The cost of shrinkage due to theft or breakage. The opportunity cost of the money invested in inventory.

2a. Gross margin is a poor measure of a product's contribution to overall profitability, because it ignores a firm’s inventory investment. For example, a product with a gross margin of 20% may contribute more to a company's overall profitability than a product with a gross margin of 30%, if it requires a smaller average inventory investment. A product’s average inventory investment depends on the cost of the item, variations in customer demand, vendor reliability, transportation costs, and purchase discounts.

2b. In calculating the gross margin, also include average inventory carrying cost.2c. Product A:

Gross Margin: ($20,000 – $14,000) ÷ $20,000 = 30%Adjusted Gross Margin: ($20,000 – $14,000 – ($10,000 × 20%)) ÷ $20,000 = 20%

20-30

Internet Exercise (Cont’d.)

Product B:

Gross Margin: ($20,000 – $15,000) ÷ $20,000 = 25%Adjusted Gross Margin: ($20,000 – $15,000 – $4,000 × 20%) ÷ $20,000 = 21%

2d. Product A has a higher gross margin, while product B has a higher adjusted gross margin.

3a. Annual sales = $10 millionGross margin = 40%Cost of goods sold = $10 (1 – 0.40) = $10 × 0.60 = $6 millionInventory turnover = COGS ÷ Inventory investmentInventory investment = COGS ÷ Inventory turnover = $6 million ÷ 5 = $1.2 million

3b. If inventory turnover can be increased to 5.5, inventory investment equals $6 million ÷ 5.5 = $1.09 million.

4. Fourteen steps of effective inventory management include:

1. Protecting your company against theft. 2. Establishing an approved stock list for each warehouse.3. Assigning and using bin locations.4. Recording all material leaving your warehouse.5. Timely processing of paperwork.6. Setting appropriate objectives for your buyers.7. Making sure employees are aware of the cost of bad inventory.8. Ensuring that stock balances are accurate and will remain accurate.9. Determining the most advantageous replenishment path for each item in each

warehouse.10. Specifying guidelines for setting reorder methods and parameters to maximize

inventory turns and minimize stock outs.11. Documenting replenishment procedures.12. Establishing customer service, inventory turnover, and return on investment goals for

each branch and major product line.13. Initiate an ongoing dead stock and excess inventory control program.14. Making inventory management considerations part of corporate strategic planning.

20-31

Chapter 20 Video Case

The video case can be discussed using only the case writeup in the chapter. Alternatively, instructors can have students view the videotape of the company that is the subject of the case. The videotape can be obtained by contacting your Prentice Hall representative. The case questions challenge students to apply the concepts learned in the chapter to a specific business situation.

REGAL MARINE: SUPPLY CHAIN MANAGEMENT

1. Regal Marine does the following: (1) Partners with upstream suppliers of direct materials and components to assure proper quality and to control costs, (2) Brings vendors and suppliers into the product design process so that new products and innovations can be designed into future products, and (3) Participates in a buying group with other boat manufacturers, called the American Boat Builders Association.

2 Regal Marine can benefit from a strong relationship not only with its upstream direct materials suppliers, but also from the downstream retail channel relationships. For example, retailers can provide retail sales forecasts for products that can help Regal Marine better plan production. Retailers can also provide sales information so Regal Marine knows which boats are fast-sellers and which don’t seem to move off the showroom floor. Regal Marine could work with its distribution network to offer pricing and promotional deals to help boost sales and push production of higher margin products.

3 There are several potential challenges to strengthening the supply chain relationship with retailers. First, communication obstacles may arise if retailers are not willing to provide Regal Marine with enough information for planning and production. Second, trust issues may arise if both sides don’t think the other will be able to meet commitments. Third, there may be some information systems obstacles in the form of incompatible systems if the company and its retailers try to automate the exchange of information. Lastly, both parties may face a shortage of human resources that prevent them from collecting, analyzing, and sharing information in a timely manner.

20-32