Management Decisions and Control 22421/0

Management Decisions
and Control
Lecture 4

Operation Costing,
Inventory Management and
Just-in-Time (JIT)
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 Lecture Objectives
1. Introduction

3. Conventional Approaches to Inventory Management

5. Economic Order Quantity (EOQ)

7. Contemporary Approaches to Managing Inventory: MRPI

and MRPII

9. Just-in-Time (JIT) Inventory Management

11. Performance Evaluation and Control in a JIT Environment

13. Total Quality Management (TQM)

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 Introduction
 Inventory management is the planning, coordinating and
controlling of activities related to the flow of inventory into,
through, and from the organisation.

 Manufacturing, wholesale and retail businesses typically hold

significant amounts of inventory, including raw materials, WIP and
finished goods.

 The reasons for carrying inventories vary from one business to the
next, but the most common reasons include:
 To cope with uncertainties in customer demand and in production
processes
 To qualify for quantity discounts
 To avoid future price increases in raw materials, and
 To avoid the costs of placing numerous small orders with suppliers

 Conventional approaches to managing inventory have focused on

minimising inventory costs by assessing how much inventory to
purchase or to manufacture in-house, and how often. Managers 3
nowandrealise
Management Decisions that inventory decisions affect the competitive stance
Control 22421/0
 Conventional Approaches
Conventional approaches to inventory management have focused on
the delicate balance among
three classes of costs: ordering costs, carrying costs and shortage costs
where:

 Ordering Costs are the incremental costs of placing an order for

inventory, or where manufactured in-house the costs of placing the
work order and setting up the plant to produce the required
inventory item.

 Carrying Costs are the costs of carrying inventory in stock,

including:
 Incremental costs, eg insurance, rent, obsolescence, spoilage and
breakage
 Opportunity costs, eg capital invested in inventory, lost CM in existing
sales due to stock-outs, and lost CM relating to future sales.

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 Shortage
Management Decisions or
and Control 22421/0 Stock-out Costs refers to the costs of running out
 Economic Order Quantity (EOQ)
EOQ determines the optimal quantity of inventory to order or to
produce, which minimise both total
ordering and carrying costs. Basic assumptions underlying the EOQ
model are:
 Demand is known and constant
 Same fixed quantity is ordered at each reorder point and the entire
order is delivered at one time
 Carrying costs and acquisition costs are known and constant per
unit
 Ordering costs are known and unaffected by the quantity ordered
 No stock-outs occur
 Ignore quality
2DP costs unless these affect either order costs or
EOQ= costs
carrying
C
D = Annual requirement
P = Costs per order
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Management Decisions and Control 22421/0 C = Annual carrying costs per unit
 Economic Order Quantity (EOQ)
Timing of Orders under EOQ
 Inventory re-order point (ROP) – the level of inventory on hand
that triggers the placement of a new order (or setup). This
decision depends on the lead time, which is the length of time
between placing and order and receiving inventory.

 Safety stock – the extra inventory kept on hand to cover any

above-average usage or demand. Although safety stock will
increase inventory carrying costs, it will minimise the potential
costs caused by shortage or stock-out: assuming uncertainty in
demand and/or lead time or cycle time

 Expediting costs – refers to the extra costs of processing

purchase or production orders faster than normal

In EOQ the inventory re-order point is calculated as follows:

ROP = (Inventory used per period of time * order lead time) +

Safety stock 6
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 Economic Order Quantity (EOQ)
There are a number of criticisms which have limited the practical
application of the EOQ model.

 There is a preference for long production runs because of high

ordering (batch-related) costs, leading to high inventory levels and
high carrying costs – Fordism: mass production and economics of
scale
 Large quantities of inventory are held because of the long lead
time
 Hold safety stocks to minimise the costs of stock-out, given
uncertainty in delivery and demand
 Hold safety stocks to enable assembly line to continue to operate
even when one or more stations at the assembly line have stopped
due to breakdowns or rework
 There is very little focus on quality factors
 Managers tend to understate the cost of carrying stocks because
the opportunity cost of carrying stocks is not included in the
assessment of managerial performance: ‘what gets measured gets
done’ 7
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 Contemporary Approaches - MRP
 Material requirements planning (MRP) is an operations
management tool that assists managers to estimate inventory
requirements and schedule production. MRP is particularly useful
in complex manufacturing operations, where there are several
production stages. The early versions of MRP (now called MRPI)
focused on inventory management.
 More recent versions also include the planning for major
manufacturing resources, such as labour and machine capacity,
the distribution of final products, and in addition some of these
systems include financial planning. These systems, called
manufacturing resource planning (or MRPII) systems, enable
managers to link production planning to the overall planning for
the business.
 Benefits of MRP:
 Increased customer responsiveness
 Increased labour productivity
 Reduced inventory levels
 MRPII improved the capacity planning and financial planning of 8
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and Control 22421/0
 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. The underlying philosophy is the simplifying of the
production process by removing non-value-added activities (see
lecture 3).

 JIT production is a demand pull system - each component in the

production line is produced immediately as needed by the next
step in the production line.

 Key features of JIT production

 A pull method of co-ordinating production, uses kanbans
 Simplified production processes
 Purchase of materials, and manufacture of sub-assemblies and products
in small lots
 Quick and inexpensive setups of production machinery
 High-quality levels for raw materials, components and finished products
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 Effective preventive
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maintenance of equipment
 Just-in-Time (JIT) Inventory
Management
 JIT purchasing
 Only a few suppliers
 Long-term contracts with suppliers
 Materials and parts delivered in small lots as needed
 Minimal inspection of delivered materials and parts
 Electronic ordering and payments

 Benefits of JIT
 Reductions in inventory-carrying and handling costs
 Lower insurance and inventory costs (no opportunity costs of high
inventory)
 Reduces costs of spoilage and obsolescence as a result of improved
quality
 Elimination of non-value-added activities
 Higher revenues as a result of meeting customers’ needs more
effectively
 Reduction in paperwork
 Lower investment in plant space for inventory and production
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 The use of
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flexible manufacturing, reduces the need for setups and
 Just-in-Time (JIT) Inventory
Management
 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 associates loss of
production, expediting materials costs and loss of sales

 JIT and ‘backflush’ costing

 The absence of inventories reduces the requirement to track costs. So,
while conventional costing tracks costs sequentially through the
physical flow of manufacturing, backflush costing waits until the
manufacturing sequence is complete and then works backwards to flush
the product costs out of the system. Hence, products are not costed
until they are completed or sold.

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 Just-in-Time (JIT) Inventory
Management
Conventional vs JIT Inventory Management

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 Performance Evaluation & JIT
Performance evaluation and control in a JIT environment builds on
personal observation by
production line workers and team leaders. Hence, compared to the
conventional inventory
systems, which used mainly financial measures such as inventory
turnover ratio, variance analysis,
JIT requires the use of both financial and non-financial measures for
performance evaluation and
control.

Non-Financial Measures used in JIT includes;

 Manufacturing lead time
 Number of defects per part million
 Number of orders meeting customers delivery requirement
 On time delivery
 Days’ inventory on hand
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 Total
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 Total Quality Management
TQM is a management approach that focuses on meeting customers
requirements by achieving
continuous improvement of product or services.

Key features of TQM:

 TQM is holistic and requires a change in organisational culture
 Customer –driven
 Involves empowerment
 Has a process perspective
 Is supported by quality management system
 Involves continuous improvement

Quality Accreditation
Organisations may achieve quality accreditation by meeting a series of
quality standards set out in
the ISO 9000 series. However, ISO 9000’s are both expensive to
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implement and
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to maintain, and