Chapter 20

Managing inventory and quality

The importance of inventory management

Cope with uncertainties in customer demand and in production processes

Qualify for quantity discountsAvoid future price increases in raw

materialsAvoid the costs of placing numerous small

orders with suppliers

Conventional approaches to inventory management

Focused on balancing ordering costs

• the incremental costs of placing an order for inventory

carrying costs• the costs of carrying inventory in stock

shortage costs (or out of stock costs)

Economic order quantity (EOQ)

The optimum order size for individual inventory items, to minimise the total ordering and carrying costs

EOQ = 2 x annual requirements x cost per order

annual carrying cost per unit

Timing of orders under EOQ

Inventory reorder point (ROP) the level of inventory on hand that triggers the

placement of a new order (or setup)

safety stock• the extra inventory kept on hand to cover any

above-average usage or demand

(inventory used per period of time + safety stock) x order lead time

Assumptions underlying EOQ

Demand is known and constantIncremental ordering costs are known,

constant per orderAcquisition cost per unit is constantEntire order is delivered at one timeCarrying costs are known, constant per unitOn average, one-half of order is in stock at

any time

MRP

Material requirements planning (MRPI) assists managers to estimate inventory

requirements and to schedule production

Manufacturing resource planning (MRPII) allows managers to link production planning to

the overall planning function of the business

MRP is a push system

MRP terminology

Bill of materials identifies all the materials, components and sub-

assemblies required to make a product

Inventory master file records the quantity of inventory on hand and

movements in and out of stock

Master production schedule identifies the quantity and timing of each item

to be produced in each department

Benefits of MRP

Increased customer responsiveness significantly more on-time deliveries much less expediting

Increased labour productivityReduced inventory levels

reduced cost of holding inventory

Costs of MRP

Expensive to installRequires extensive employee training and

disciplineIf bill of materials or inventory master files

are inaccurate - system is unreliable

Just-in-time (JIT) inventory management

JIT inventory and production system is a comprehensive system for controlling the

flow of manufacturing in a multistage production environment

An underlying philosophy of simplifying the production process by removing non-value-added activities

Key features of JIT production

A pull method of co-ordinating production, uses kanbans

Simplified production processesPurchase of materials, and manufacture of

sub-assemblies and products in small lotsQuick and inexpensive setups of production

machinery

Cont.

Key features of JIT production

High-quality levels for raw materials, components and finished products

Effective preventative maintenance of equipment

Flexible work cells to take advantage of group technology and

remove bottlenecks

JIT purchasing

A few suppliersLong-term contracts with suppliersMaterials and parts delivered in small lots

as neededMinimal inspection of delivered materials

and partsGrouped payments to each supplier

Costs of JIT

Substantial investment to change the production to minimise non-value-added activities

An increase in the risk of inventory shortages and the associated loss of production, expediting materials costs and loss of sales

Benefits of JIT

Savings in inventory-carrying costsLower insurance costsFewer losses due to spoilage, obsolescence

and theftNo opportunity costs of high inventoryElimination of non-value-added activitiesMeets customers needs more effectively

JIT and backflush costing

Backflush costing a simplified method of product costing under

JIT no raw material or WIP inventory account raw material charged to raw and in process

inventory (RIP) account used conversion costs charged to finished goods

inventory

Costs and benefits of backflush costing

Benefits of backflush costing simpler and less expensive than conventional

costing

Costs of backflush costing are provides much less detail than conventional

costing

Is the loss of detail overcome by cost savings?

Role of the management accountant in managing inventory

MPR: may maintain inventory master files and bills of material for all products

JIT co-ordinate the flow of information to eliminate

non-value activities provide reports to appropriate levels of

management

Managing quality

TQM is a management approach that focuses on meeting customer requirements by achieving continuous improvement in products or services

TQM is a broad philosophy with a number of features which are not included in JIT

Quality accreditation

Organisations may achieve quality accreditation by meeting a series of quality standards set out in the ISO 9000 series.

ISO 9000’s are expensive to implement and maintain may have little relevance to many small

businesses and service organisations

Quality accreditation (QA) versus total quality management (TQM)

Organisations can have QA without TQMTQM is a philosophy - QA is a

documentation processQA may encourage employees to think

about quality

Features of TQM

TQM is holisticCustomer-drivenInvolves empowermentHas a process perspectiveIs supported by a quality management

systemInvolves continuous improvement

Benefits and costs of TQM

Benefits improved quality shorter lead times increased efficiency improved customer satisfaction

TQM can be difficult and expensive to achieve because it may involve a change in organisational culture

Cost of quality reports

Quality of design degree to which a product’s design

specifications meet customers’ expectations

Quality of conformance degree to which a product meets formal design

specifications

Cont.

Cost of quality reports

Costs incurred in ensuring that the organisation maintains a high level of quality in its products, and the costs that arise from having poor-quality products

Internal failure costs incurred when defective products or services

are detected before they leave the firm

Cost of quality reports

External failure costs incurred as a result of defective products or

services being delivered to customers

Appraisal costs incurred to determine whether defects exist

Prevention costs incurred to prevent internal or external failures

and to minimise appraisal activities

Usefulness of cost of quality reports

Places a dollar figure on the costs of poor quality

Helps prioritise quality improvement programsHelps managers monitor the effects of the

‘quality effort’Can help identify the optimal level of quality

for the firm

Reasons for lack of use of cost of quality reports

Managers may believe costs outweigh the benefits

Information is difficult to extract from conventional costing systems

Many of the quality costs are spread across the organisation

Exhibit 20.3

Exhibit 20.4

Exhibit 20.6