Cost 20

Inventory Management,
Just-in-Time, and
Backflush Costing
Chapter 20
20 - 1
Introduction
■ Inventory management is a pivotal part of

profit planning for manufacturing and
merchandising companies.
■ Accounting information can play a key role
in inventory management.
20 - 2
Learning Objectives
1 Identify five categories of costs associated with

goods for sale
2 Balance ordering costs and carrying costs using
the economic-order-quantity (EOQ) decision
model
3 Identify and reduce conflicts that can arise
between EOQ decision models and models
used for performance evaluation
20 - 3
Learning Objectives
4 Use a supply-chain approach to inventory

management
5 Differentiate materials requirements planning
(MRP) systems from just-in-time (JIT)
systems for manufacturing
20 - 4
Learning Objectives
6 Identify the major features of a just-in-time

production system
7 Use backflush costing
8 Describe different ways backflush costing
can simplify traditional job-costing systems
20 - 5
Learning Objective 1
Identify five categories of costs

associated with goods for sale
20 - 6
Costs Associated with
Goods for Sale
■ Five categories of costs associated with
goods for sale are:
1 Purchasing costs
2 Ordering costs
3 Carrying costs
4 Stockout costs
5 Quality costs
20 - 7
Purchasing Costs
■ Purchasing costs are the costs of goods

acquired from suppliers including incoming
freight or transportation costs.
■ These costs usually make up the largest single
cost category of goods for sale.
■ Discounts for different purchase-order sizes
and supplier credit terms affect purchasing
costs.
20 - 8
Ordering Costs
■ Ordering costs are the costs of preparing,

issuing, and paying purchase orders, plus
receiving and inspecting the items included
in the orders.
■ Purchase approval and special processing
costs are related to the number of purchase
orders processed.
20 - 9
Carrying Costs
■ Carrying costs arise when an organization

holds an inventory of goods for sale.
■ These costs include the opportunity cost of
the investment tied up in inventory and the
costs associated with storage such as space
rental, insurance, obsolescence, and spoilage.
20 - 10
Stockout Costs
■ A stockout cost occurs when an organization

runs out of a particular item for which there
is a customer demand.
■ Expediting costs of a stockout include:
– Additional ordering costs
– Associated transportation costs
20 - 11
Stockout Costs
■ Opportunity cost of a stockout includes:

– Lost contribution margin on the sale not made
– Any contribution margin lost on future sales
hurt by customer ill-will caused by the
stockout.
20 - 12
Quality Costs
■ Quality costs of a product or service is its lack of

conformance with a preannounced or
prespecified standard.
■ There are four categories of costs of quality:
1 Prevention costs
2 Appraisal costs
3 Internal failure costs
4 External failure costs
20 - 13
Balance ordering costs and

carrying costs using the
economic-order-quantity
(EOQ) decision model
20 - 14
Economic-Order-Quantity
Decision Model
■ The economic-order-quantity (EOQ) is a
decision model that calculates the optimal
quantity of inventory to order under a
restrictive set of assumptions.
■ The simplest version of this model
incorporates only ordering costs and carrying
costs into the calculations.
20 - 15
Decision Model
■ Assumptions:
1 The same fixed quantity is ordered at each
reorder point.
2 Demand, ordering costs, and carrying costs are
known with certainty.
3 Purchase-order lead time – the time between
placing of an order and its delivery – is also
known with certainty.
20 - 16
Decision Model
4 Purchasing costs per unit are unaffected by the
quantity ordered.
5 No stockouts occur. One justification for this
assumption is that the costs of a stockout can be
prohibitively high.
6 In deciding the size of the purchase order, managers
consider the costs of quality only to the extent that
these costs affect ordering costs or carrying costs.
20 - 17
Decision Model
■ The EOQ minimizes the relevant ordering costs
and carrying costs.
■ Relevant total costs = Relevant ordering costs +
Relevant carrying costs
■ Little Video store sells packages of blank video
tapes.
■ Little Video purchases packages of video tapes
from White Oaks, Inc., at $15/package.
20 - 18
Decision Model
■ Annual demand is 12,844 packages, at the
rate of 247 packages per week.
■ Little Video requires a 15% annual return on
investment.
■ The purchase-order lead time is two weeks.
■ What is the economic-order-quantity?
20 - 19
Decision Model
■ Little Video additional data: Relevant
ordering cots per purchase order $209
Relevant carrying costs per
package per year:
Required annual return on
investment (15% × $15) $2.25 Relevant other
costs 3.25 $5.50
20 - 20
Decision Model
The formula for the EOQ model is:
EOQ = 2 DP
C
D = Demand in units for a specified time period
P = Relevant ordering costs per purchase order
C = Relevant carrying costs of one unit in
stock for the time period used for D
20 - 21
Decision Model
EOQ = 2 x12 ,844 x$209

$5.50
EOQ = 976
EOQ ,144
= 988
■ Little Video should purchase 988 tape packages
per order to minimize total ordering and
carrying costs.
20 - 22
Decision Model
■ What are the relevant total costs?
■ The formula for annual relevant costs (RTC) is: RTC =
Annual relevant ordering costs + Annual relevant
carrying costs
RTC =
D ( ) Q× P + ( ) ×DP
C= QC+
Q 2 Q 2
■ Q can be any order quantity, not just the EOQ.
20 - 23
Decision Model
■ When Q = 988 units,
■ RTC = 12,844 × $209 + 988 × $5.50 =
988 2
$5,434 total relevant costs
20 - 24
Decision Model
■ How many deliveries should occur each time
period?
■ The number of deliveries each time period is:
D 12,844
EOQ = = 13 deliveries
988
20 - 25
10,000 Decision Model
Relevant Total Costs (Dollars)
8,000
Annual relevant
total costs
6,000
5,434
4,000 Annual relevant

ordering costs
Annual relevant
carrying costs
2,000
600 988 1,200 1,800 2,400

Order Quantity (Units) EOQ 20 - 26
Reorder Point
■ The reorder point is the quantity level of the

inventory on hand that triggers a new order.
■ The reorder point is simplest to compute
when both demand and purchase-order lead
time are known with certainty.
■ Reorder point = Number of units sold per unit
of time × Purchase-order lead time
20 - 27
Reorder Point
■ What is the reorder point for Little Video?

– Economic order quantity = 988 packages
– Number of units sold/week = 247 packages

– Purchase-order lead time = 2 weeks
■ Reorder point = 247 × 2 = 494 packages
20 - 28
Reorder Point
■ Little Video will order 988 packages of tapes

each time its inventory stock falls to 494
packages.
20 - 29
Reorder Point
988
Reorder Reorder
Point Point
494
Weeks 1 2 3 4 5 6 7 8
Lead Time
2 weeks
This exhibit assumes that demand and purchase-order lead time are certain:
Demand = 247 tape packages/week Purchase-order lead time = 2 weeks
20 - 30
Safety Stock
■ Safety stock is inventory held at all times

regardless of the quantity of inventory
ordered using the EOQ model.
■ Safety stock is used as a buffer against
unexpected increases in demand or lead time
and unavailability of stock from suppliers.
20 - 31
Safety Stock
■ Little Video’s expected demand is 247

packages per week.
■ Management feels that a maximum demand
of 350 packages per week may occur.
■ Management decides that the costs of
stockouts are prohibitive.
■ How much safety stock should be carried?
20 - 32
Safety Stock
■ 350 Maximum demand – 247 Expected

demand = 103 Excess demand per week
■ 103 packages × 2 weeks lead time = 206
packages of safety stock.
20 - 33
Considerations in Obtaining
Estimates of Relevant Costs
■ Obtaining accurate estimates of the cost
parameters used in the EOQ decision model is
a challenging task.
■ What are the relevant incremental costs of
carrying inventory?
– Only those costs of the purchasing company
that change with the quantity of inventory held
20 - 34
Considerations in Obtaining
Estimates of Relevant Costs
■ What is the relevant opportunity cost of
capital?
– It is the return forgone by investing capital in
inventory rather than elsewhere.
– It is calculated as the required rate of return
multiplied by those costs per unit that vary with
the number of units purchased and that are
incurred at the time the units are received.
20 - 35
Cost of Prediction Error
■ Predicting relevant costs requires care and is

difficult.
■ Assume that Little Video’s relevant ordering
cost is $97.84 instead of the $209 prediction
used.
■ What is the cost of this prediction error?
20 - 36
■ Step 1: Compute the monetary outcome from

the best action that could have been
taken, given the actual amount of the
cost input.
2 x 12 ,844 x 97 .84
EOQ = $5 .50
EOQ 456 ,966

= packages
= 676 (approx.)
20 - 37
■ The annual relevant total costs when EOQ

is 767 packages is:
DP QC
RTC = +
Q 2
12,844 × $97.84 + 676 × $5.5 = $3,718
676 2
20 - 38
■ Step 2: Compute the monetary outcome from

the best action based on the incorrect
amount of the predicted cost input.
■ The planned action when the relevant ordering
costs per purchase order are predicted to be
$209 is to purchase 988 packages in each
order.
20 - 39
■ What are the annual relevant costs using

this order quantity when D = 12,844 units,
P = $97.84, and C = $5.50?
■ RTC = 12,844 × $97.84 + 988 × $5.5
988 2
■ RTC = $3,989
20 - 40
■ Step 3: Compute the difference between the

monetary outcomes from Steps 1 & 2.
■ Monetary Outcome
Step 1 $3,718
Step 2 3,989
Difference $ (271)
■ The cost of prediction error is $271.
20 - 41
Identify and reduce conflicts

that can arise between EOQ
decision models and models
used for performance
evaluation
20 - 42
Evaluating Managers and
Goal-Congruence Issues
■ Goal-congruence issues can arise when there
is an inconsistency between the EOQ decision
model and the model used to evaluate the
performance of the manager implementing
the inventory management decisions.
20 - 43
Evaluating Managers and
Goal-Congruence Issues
■ The opportunity cost of investment tied up in
inventory is a key input in the EOQ decision
model.
■ Some companies now include opportunity
costs as well as actual costs when evaluating
managers so that there is goal-congruence
between managers and the company.
20 - 44
Just-In-Time Purchasing
■ Just-in-time (JIT) purchasing is the purchase

of goods or materials such that a delivery
immediately precedes demand or use.
■ Just-in-time purchasing can be implemented
in both the retail and manufacturing sectors
of the economy.
20 - 45
JIT Purchasing and EOQ
Model Parameters
■ Companies moving toward JIT purchasing
argue that the cost of carrying inventories
(parameter C in the EOQ model) has been
dramatically underestimated in the past.
■ This cost includes storage costs, spoilage,
obsolescence, and opportunity costs such as
investment tied up in inventory.
20 - 46
Model Parameters
■ The cost of placing a purchase order
(parameter P in the EOQ model) is also
being re-evaluated.
■ Three factors are causing sizable reduction
in the cost of placing a purchase order (P).
1 Companies increasingly are establishing
long-run purchasing arrangements.
20 - 47
Model Parameters
2 Companies are using electronic link, such as
the Internet, to place purchase orders.
3 Companies are increasing the use of purchase
order cards (similar to consumer credit cards
like Visa and Master Card).
■ Both increases in the carrying cost (C) and
decreases in the ordering cost per purchase
order (P) result in smaller EOQ amounts.
20 - 48
Relevant Costs of JIT Purchasing
■ When comparing two or more purchasing

policies the analysis should include only
the relevant costs – those costs that differ
between alternatives.
■ The difference between two incremental
costs is the relevant savings from choosing
a given purchasing policy.
20 - 49
Supplier Evaluation
■ The timely delivery of quality products is

particularly crucial in JIT purchasing
environments.
■ Defective goods and late deliveries often result
in contribution margin lost on current and
future sales.
■ Companies that implement JIT purchasing
choose their suppliers carefully.
20 - 50
Supplier Evaluation
■ What are some examples of relevant costs?

– Purchasing costs
– Ordering costs
– Inspection costs
– Stockout costs
– Customer returns costs
– Outlay carrying costs
20 - 51
Use a supply-chain approach

to inventory management
20 - 52
Supply-Chain Analysis
■ The level of inventory held by retailers is

influenced by demand patterns of their
customers and supply relationships with their
distributors, manufacturers, and suppliers.
20 - 53
■ Supply-chain analysis describes the flow of

goods, services, and information from cradle
to grave, regardless of whether those activities
occur in the same organization or other
organizations.
■ There are significant total gains to companies
in the supply chain from coordinating their
activities and sharing information.
20 - 54
■ The higher level of variability at suppliers

than at manufacturers, and at manufacturers
than at retailers, is called the “bullwhip effect”
or the “whiplash effect.”
■ One consequence of the bullwhip effect is
that high levels of inventory are often held
at various stages in the supply chain.
20 - 55
■ There are multiple gains to companies in a

supply chain by coordinating their activities
and sharing information.
■ Updated sales information reduces the level
of uncertainty that manufacturers and
suppliers have about retail demand.
20 - 56
■ A reduction in demand uncertainty may...

– lead to fewer stockouts at the retail level.
– reduce the number of units manufactured not
subsequently demanded by retailers.
– reduce the number of expedited manufacturing
orders.
– lower inventories being held by each company in
the supply chain.
20 - 57
Differentiate materials
requirements planning (MRP)
systems from just-in-time (JIT)
systems for manufacturing
20 - 58
Materials Requirement
Planning (MRP)
■ Materials requirements planning (MRP)
systems take a “push-through” approach that
manufactures finished goods for inventory on
the basis of demand forecasts.
■ MRP predetermines the necessary outputs at
each stage of production.
■ Inventory management is a key challenge in an
MRP system.
20 - 59
Planning (MRP)
■ Materials requirement planning uses...
– demand forecasts for the final products.
– a bill of materials outlining the materials,
components and subassemblies of each final
product.
– the quantities of materials, components,
finished products and product inventories.
20 - 60
Planning (MRP)
■ Management accountants play key roles in an
MRP system, including...
1 maintaining accurate and timely information
pertaining to materials, work in process, and
finished goods, and...
2 providing estimates of the setup costs for each
production run at a plant, the downtime costs,
and carrying costs of inventory.
20 - 61
Identify the major features of a

just-in-time production system
20 - 62
Just-In-Time Production Systems
■ Just-in-time (JIT) production systems take a

“demand pull” approach in which goods are
only manufactured to satisfy customer orders.
■ Demand triggers each step of the production
process, starting with customer demand for a
finished product at the end of the process, to
the demand for direct materials at the
beginning of the process.
20 - 63
Major Features of a JIT System
■ JIT production systems aim to simultaneously

meet customer demand in a timely way...
– with high quality products, and...
– at the lowest possible total cost.
20 - 64
Major Features of a JIT System
■ The five major features of a JIT system are:

1 Organizing production in manufacturing cells
2 Hiring and retaining multi-skilled workers
3 Emphasizing total quality management
4 Reducing manufacturing lead time and setup
time
5 Building strong supplier relationships
20 - 65
Benefits of JIT Systems
■ Benefits of JIT production:

– Lower carrying costs of inventory
– Eliminating the root causes of rework, scrap,
waste, and manufacturing lead time.
20 - 66
Performance Measures and
Control in JIT Production
■ To manage and reduce inventories, the
management accountant must design
performance measures to control and evaluate
JIT production.
■ What information may management
accountants use?
– Personal observation by production line
workers and managers
20 - 67
– Financial performance measures, such as
inventory turnover ratios
■ What are nonfinancial performance measures
of time, inventory, and quality?
– Manufacturing lead time
– Units produced per hour
– Days’ inventory on hand
20 - 68
– Total setup time for machines/Total
manufacturing time
– Number of units requiring rework or
scrap/Total number of units started and
completed
20 - 69
JIT’s Effect on Costing Systems
■ In reducing the need for materials handling,

warehousing and incoming inspection, JIT
systems reduce overhead costs.
■ JIT systems also facilitate the direct tracing
of some costs that were formerly classified
as overhead.
20 - 70
Use backflush costing
20 - 71
Backflush Costing
■ A unique production system such as JIT often

leads to its own unique costing system.
■ Organizing manufacturing in cells, reducing
defects and manufacturing lead time, and
ensuring timely delivery of materials enables
purchasing, production, and sales to occur in
quick succession with minimal inventories.
20 - 72
Backflush Costing
■ Traditional normal and standard costing

systems use sequential tracking.
■ Sequential tracking is any product-costing
method where recording of the journal entries
occurs in the same order as actual purchases
and progress in production.
20 - 73
Backflush Costing
■ Backflush costing describes a costing system

that delays recording some or all of the
journal entries relating to the cycle from
purchase of direct materials to the sale of
finished goods.
20 - 74
Backflush Costing
■ 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 - 75
Describe different ways

backflush costing can simplify
traditional job-costing systems
20 - 76
Trigger Points
■ The term trigger point refers to a stage in a

cycle going from purchase of direct materials
to sale of finished goods at which journal
entries are made in the accounting system.
■ A sequential tracking costing system would
have four trigger points, corresponding to
separate journal entries being made at
different stages.
20 - 77
Trigger Points
■ Stage A: Purchase of direct materials

■ Stage B: Production resulting in work in
process
■ Stage C: Completion of a good finished unit
or product
■ Stage D: Sale of finished goods
20 - 78
Trigger Points
■ Assume trigger points A, C, and D.

■ This company would have two inventory accounts:
■ Type Account Title 1.
Combined materials Inventory: Raw and materials in
work-in- and In-Process process inventory Control
■ 2. Finished goods Finished Goods Control
20 - 79
Trigger Points
■ What is the journal entry when trigger point

A occurs?
■ Inventory: Raw and
In-Process Control XX
Accounts Payable Control
XX To record direct material purchased
during the period
20 - 80
Trigger Points
■ What is the journal entry to record conversion

costs?
■ Conversion Costs Control XX
Various accounts XX
To record the incurrence of conversion costs
during the accounting period
■ Underallocated or overallocated conversion
costs are written off to cost of goods sold.
20 - 81
Trigger Points

C occurs?
■ Finished Goods Control XX
Inventory: Raw and
Conversion Costs Allocated
XX To record the cost of goods
completed during the accounting period
20 - 82
Trigger Points

D occurs?
■ Cost of Goods Sold XX
Finished Goods Control XX
To record the cost of goods sold during the
accounting period
20 - 83
Trigger Points
■ Assume trigger points A and D.

■ This company would have one inventory account:
■ Type Account Title
Combines direct materials Inventory
inventory and any direct Control
materials in work-in-process and
finished goods inventories
20 - 84
Trigger Points
■ What is the journal entry when trigger point A

occurs?
■ Inventory: Raw and
Accounts Payable Control XX To
record direct material purchased during the
period
■ Same as the A, C, and D example.
20 - 85
Trigger Points

costs?
Various accounts XX
To record the incurrence of conversion
costs during the accounting period
20 - 86
Trigger Points
■ What is the journal entry to record the cost

of goods completed during the accounting
period (trigger point C)?
■ No journal entry.
20 - 87
Trigger Points

D occurs?
Inventory Control XX
Conversion Costs Allocated XX
accounting period
20 - 88
Trigger Points
■ Assume trigger points C and D.

A occurs?
■ No journal entry.
20 - 89
Trigger Points

costs?
Various accounts XX
To record the incurrence of conversion
costs during the accounting period
20 - 90
Trigger Points
■ What is the journal entry to record the cost

of goods completed during the accounting
period (trigger point C) ?
■ Finished Goods Control XX
Accounts Payable Control XX
Conversion Costs Allocated XX
To record the cost of goods
completed during the accounting period
20 - 91
Trigger Points

D occurs?
Finished Goods Control XX
accounting period
20 - 92
End of Chapter 20
20 - 93

Cost 20

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Cost 20

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Inventory Management,

■ Inventory management is a pivotal part of

1 Identify five categories of costs associated with

4 Use a supply-chain approach to inventory

6 Identify the major features of a just-in-time

Identify five categories of costs

■ Purchasing costs are the costs of goods

■ Ordering costs are the costs of preparing,

■ Carrying costs arise when an organization

■ A stockout cost occurs when an organization

■ Opportunity cost of a stockout includes:

■ Quality costs of a product or service is its lack of

Balance ordering costs and

EOQ = 2 x12 ,844 x$209

■ Q can be any order quantity, not just the EOQ.

4,000 Annual relevant

600 988 1,200 1,800 2,400

■ The reorder point is the quantity level of the

■ What is the reorder point for Little Video?

– Number of units sold/week = 247 packages

■ Little Video will order 988 packages of tapes

■ Safety stock is inventory held at all times

■ Little Video’s expected demand is 247

■ 350 Maximum demand – 247 Expected

■ Predicting relevant costs requires care and is

■ Step 1: Compute the monetary outcome from

EOQ 456 ,966

■ The annual relevant total costs when EOQ

■ Step 2: Compute the monetary outcome from

■ What are the annual relevant costs using

■ Step 3: Compute the difference between the

Identify and reduce conflicts

■ Just-in-time (JIT) purchasing is the purchase

■ When comparing two or more purchasing

■ The timely delivery of quality products is

■ What are some examples of relevant costs?

Use a supply-chain approach

■ The level of inventory held by retailers is

■ Supply-chain analysis describes the flow of

■ The higher level of variability at suppliers

■ There are multiple gains to companies in a

■ A reduction in demand uncertainty may...

Identify the major features of a

■ Just-in-time (JIT) production systems take a

■ JIT production systems aim to simultaneously

■ The five major features of a JIT system are:

■ Benefits of JIT production:

■ In reducing the need for materials handling,

Use backflush costing

■ A unique production system such as JIT often

■ Traditional normal and standard costing

■ Backflush costing describes a costing system

■ Where journal entries for one or more stages

Describe different ways

■ The term trigger point refers to a stage in a

■ Stage A: Purchase of direct materials

■ Assume trigger points A, C, and D.

■ What is the journal entry when trigger point

■ What is the journal entry to record conversion

■ What is the journal entry when trigger point

■ What is the journal entry when trigger point

■ Assume trigger points A and D.

■ What is the journal entry when trigger point A