COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan Chapter 21 Inventory Management: Economic Order Quantity, JIT, and the Theory of Constraints COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning Cengage Learning and South-Western are trademarks used herein under license Study Objectives Describe the just-in-case inventory management model Discuss just-in-time (JIT) inventory management Explain the basic concepts of constrained optimization Define the theory of constraints, and tell how it can be used to manage inventory 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 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 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 Just-in-Case Inventory Management Just-in-Case Inventory Management Economic Order Quantity TC = PD/Q + CQ/2 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 Just-in-Case Inventory Management Economic Order Quantity illustrated Assume P= $40 per order D= 25,000 units C= $2 per unitEOQ =  2DP �C  = (2 �25,000 �50) �$2 = 1,000,000 = 1,000 Just-in-Case Inventory Management 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 days What is the reorder point? Reorder point = rate of usage × lead time = × 100 = 400 units An order should be placed when inventory drops to 400 units Just-in-Case Inventory Management 10 JIT Inventory Management 17 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 18 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 19 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 20 Basic Concepts of Constrained Optimization Linear Programming A method that searches among possible solutions until the optimal solution is identified Example: Two products, X and Y, provide contribution margins of $300 and $600, respectively The objective function: Z = $300X + $600Y The objective is to maximize total contribution margin 21 Basic Concepts of Constrained Optimization Linear Programming 22 Basic Concepts of Constrained Optimization Internal constraints: X+Y � 80 X + 3Y �120 2C + Y � 90 External constraints: X � 60 Y �100 Linear Programming X+Y X + 3Y 2C + Y X Y X Y � 80 �120 � 90 � 60 �100 � � 23 Basic Concepts of Constrained Optimization 24 Basic Concepts of Constrained Optimization Linear Programming Corner Point X-Value Y-Value Z = $300X + $600Y A 0 $ B 40 24,000 C 30 30 27,000 D 45 13,500 C is the optimal solution! 25 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 Sales - Unit-level  Rev Var Exp  *Throughput = 26 Time 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 • Elevate the organization’s binding constraints • Repeat the process as a new constraint emerges to limit output 27 Theory of Constraints 28 Theory of Constraints 29 Theory of Constraints 30 COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan End Chapter 21 COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning Cengage Learning and South-Western are trademarks used herein under license 31 ... Constraints 30 COST MANAGEMENT Accounting & Control Hansen Mowen Guan End Chapter 21 COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning Cengage Learning and South-Western... inventory on hand when needed Just-in-Case Inventory Management Ordering Costs: The costs of placing and receiving an order Examples: Clerical costs, documents, insurance for shipment, and unloading... Just-in-Case Inventory Management Economic Order Quantity TC = PD/Q + CQ/2 Where TC = The total ordering (or setup) and carrying cost P= The cost of placing and receiving an order (or the cost of setting