Cost concepts for decision making. Management Accounting Fundamentals. Part 1. Topic 9.1

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1 Management Accounting Fundamentals Module 9 elevant costs for decision making and inventory management Lectures and handouts by: Shirley Mauger, MBA, HB Comm, CGA Part N/A Module 9 - Table of Contents Content 9.1 Cost concepts for decision making 9.2 Adding and dropping product lines 9.3 The make or buy decision 9.4 Computer illustration 9.4-1: elevant costs 9.5 Special orders 9.6 Utilization of a constrained resource 9.7 Joint product costs and the contribution approach 9.8 Economic order quantity (EOQ) and the reorder point eview question: elevant cost analysis eview question: etain or drop a department, make or buy decision eview question: Economic order quantity and safety stock eview question: Multiple choice questions 2 MA1 MODULE 9 Part 1 Cost concepts for decision making Topic

2 Part 1 Cost concepts for decision making (Topic 9.1) Identify sunk costs and explain why they are not relevant in decision making based on a general rule for distinguishing between relevant and irrelevant costs. (Level 1) Formulating longand short-term plans (Planning) Comparing actual to planned performance (Controlling) Decision Making Implementing plans (Directing and Motivating) Measuring performance (Controlling) Garrison, Noreen, Chesley, Carroll, Managerial Accounting, 6 th Canadian edition, 2004 p. 6 4 Part 1 Cost concepts for decision making (Topic 9.1) Short term decisions Adding and dropping product lines or segments Make or buy Special orders Utilization of a constrained resource Sell or process further P Part 1 Cost concepts for decision making (Topic 9.1) Short term decisions Adding and dropping product lines or segments Make or buy Special orders Utilization of a constrained resource Sell or process further elevant costs Irrelevant costs A cost that differs between alternatives. A cost that can be ignored in the analysis. p

3 Part 1 Cost concepts for decision making (Topic 9.1) Avoidable/differential cost Future costs that don t differ between alternatives Sunk cost Opportunity cost elevant Irrelevant Different costs for different purposes Whether a cost is relevant or irrelevant depends on the circumstances. p Part 1 Cost concepts for decision making (Topic 9.1) Avoidable/differential cost Future costs that don t differ between alternatives Sunk cost Opportunity cost elevant Irrelevant Can be eliminated in whole or in part by choosing one alternative over another. Department manager s salary if the department is eliminated. Savings in direct materials cost because of the purchase of a new machine. p Part 1 Cost concepts for decision making (Topic 9.1) Avoidable/differential cost Future costs that don t differ between alternatives Sunk cost Opportunity cost elevant Irrelevant Any cost in the future that will occur no matter which alternative is chosen Lease cost on the building which will continue to be used whether or not the new equipment is installed. Maintenance cost of existing equipment that will be kept whether or not the new product line is manufactured. p

4 Part 1 Cost concepts for decision making (Topic 9.1) Avoidable/differential cost Future costs that don t differ between alternatives Sunk cost Opportunity cost elevant Irrelevant Any cost that has already been incurred and cannot be changed Money that a corporation spent last year to investigate the site for a new office, expensed those funds and now is deciding whether or not to go forward with the project. Book value of old equipment that cannot be resold. p Part 1 Cost concepts for decision making (Topic 9.1) Avoidable/differential cost Future costs that don t differ between alternatives Sunk cost Opportunity cost elevant Irrelevant The potential benefit foregone when one alternative is chosen over another evenue lost because the retail outlet closes early on the weekends. Potential loss of investment income due to stockpiling inventory. Seldom recognized on financial reports. p MA1 MODULE 9 Part 2 Adding and dropping product lines Topic

5 Part 2 Adding and dropping product lines (Topic 9.2) Prepare an analysis showing whether a product line or other organizational segment should be dropped or retained. (Level 1) Adding and dropping product lines Two approaches to the cost analysis: 1. Compare all costs 2. Compare only differential costs (those that differ between alternatives) p Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page 597 First classify the costs: Variable costs Depreciation on van Liability insurance Program administrators salary General administrative overhead elevant/ Irrelevant I I Stop the audio, turn to exercise 12-2, page 597 and the handout, page 1 then come back to listen to the solution. p Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page 597 First classify the costs: Variable costs Depreciation on van Liability insurance Program administrators salary General administrative overhead elevant/ Irrelevant I I Stop the audio, turn to exercise 12-2, page 597 and the handout, page 1 then come back to listen to the solution. p

6 Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page Compare all costs Current House-keeping Total Dropped Difference evenues $900,000 $660,000 $(240,000) Less variable expenses 490, , ,000 Contribution margin 410, ,000 (80,000) Variable costs are avoidable p Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page Compare all costs Current House-keeping Total Dropped Difference evenues $900,000 $660,000 $(240,000) Less variable expenses 490, , ,000 Contribution margin 410, ,000 (80,000) Less fixed expenses: Depreciation 68,000 68,000 0 Liability insurance 42,000 27,000 15,000 Depreciation is based on the van which is a sunk cost. Liability insurance is an avoidable cost. p Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page Compare all costs Current House-keeping Total Dropped Difference evenues Cost of administrator s $900,000 salary $660,000 $(240,000) Less variable expenses is avoidable. 490, , ,000 Contribution margin General administrative 410, ,000 (80,000) Less fixed expenses: overhead is not avoidable. Depreciation 68,000 68,000 0 Liability insurance 42,000 27,000 15,000 Program admin. salaries 115,000 78,000 37,000 General administrative overhead 180, ,000 0 Total fixed expenses 405, ,000 52,000 Net operating income/loss $ 5,000 $(23,000) $ (28,000) p

7 Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior If the housekeeping Services service is dropped, net Exercise 12-2, page 597 income will be reduced by $28, Compare all costs Current House-keeping Total Dropped Difference evenues $900,000 $660,000 $(240,000) Less variable expenses 490, , ,000 Contribution margin 410, ,000 (80,000) Less fixed expenses: Depreciation 68,000 68,000 0 Liability insurance 42,000 27,000 15,000 Program admin. salaries 115,000 78,000 37,000 General administrative overhead 180, ,000 0 Total fixed expenses 405, ,000 52,000 Net operating income/loss $ 5,000 $(23,000) $ (28,000) p Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Compare lost contribution margin Exercise 12-2, page 597 to costs that can be avoided. 1. Compare all costs (elevant costs) Current House-keeping Total Dropped Difference evenues $900,000 $660,000 $(240,000) Less variable expenses 490, , ,000 Contribution margin 410, ,000 (80,000) Less fixed expenses: Depreciation 68,000 68,000 0 Liability insurance 42,000 27,000 15,000 Program admin. salaries 115,000 78,000 37,000 General administrative overhead 180, ,000 0 Total fixed expenses 405, ,000 52,000 Net operating income/loss $ 5,000 $(23,000) $ (28,000) p Part 2 Adding and dropping product lines (Topic 9.2) Ignoring the irrelevant costs, Cumberland County Senior Services will give the same answer. Exercise 12-2, page Compare differential costs Difference Contribution margin lost if housekeeping is dropped (80,000) Less fixed costs that can be avoided Liability insurance 15,000 Program admin. salaries 37,000 Total traceable fixed expenses 52,000 Net annual cost increase $ (28,000) p

8 Part 2 Adding and dropping product lines (Topic 9.2) Segment reporting format Sales (Variable costs) = Contribution margin (Traceable fixed costs) = Segment margin (Common costs) = Net income Segmented statements module 8 Corporate wide income 22 Deduct variable expenses. Housekeeping has a 33% contribution margin. ($80,000/$240,000) p Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page 597, req. 2 Home Meals on Housekeeping Total Nursing Wheels evenues $900,000 $260,000 $400,000 $240,000 Less variable expenses 490, , , ,000 Contribution margin 410, , ,000 80,000 Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page 597, req. 2 Home Meals on Housekeeping Total Nursing Wheels evenues $900,000 $260,000 $400,000 $240,000 Less variable expenses 490, , , ,000 Contribution margin 410, , ,000 80,000 Less traceable fixed expenses: Depreciation 68,000 8,000 40,000 20,000 Liability insurance 42,000 20,000 7,000 15,000 Program administrators salaries 115,000 40,000 38,000 37,000 Total traceable fixed expenses 225,000 68,000 85,000 72,000 Program segment margins $185,000 $ 72,000 $105,000 $ 8,000 Deduct fixed costs that can be traced to the department. p

9 Part 2 Adding and dropping product lines (Topic 9.2) Cumberland County Senior Services Exercise 12-2, page 597, req. 2 Home Meals on Housekeeping Total Nursing Wheels evenues $900,000 $260,000 $400,000 $240,000 Less variable expenses 490, , , ,000 Contribution margin 410, , ,000 80,000 Less traceable fixed expenses: Depreciation 68,000 8,000 40,000 20,000 Liability insurance 42,000 20,000 7,000 15,000 Program administrators salaries 115,000 40,000 38,000 37,000 Total traceable fixed expenses 225,000 68,000 85,000 72,000 Program segment margins 185,000 $ 72,000 $105,000 $ 8,000 General administrative Deduct common overhead 180,000 costs from the Net operating income/loss $ 5,000 corporate wide total. p Part 2 Adding and dropping product lines (Topic 9.2) Qualitative factors to consider: Is the line necessary to the sale of other products? Does the line serve as a magnet to attract customers? p MA1 MODULE 9 Part 3 The make or buy decision Special orders Topics 9.3 &

10 Part 3 The make or buy decision (Topic 9.3) Explain what is meant by a make or buy decision and prepare a make or buy analysis. (Level 1) Vertical integration: When a company is involved in the production of more than one or more steps in the production and distribution of the product. (value chain) Make or buy decision: Decision as to whether a product should be made internally or purchased from an outside supplier. Common steps in an organization s value chain. Product Customer &D Design Manufacturing Marketing Distribution Service McGraw-Hill yerson Limited., 2009 p Part 3 The make or buy decision (Topic 9.3) Advantages of integration: Less dependence on suppliers. Smoother flow of parts and materials. More control over quality. Disadvantages of integration Suppliers may be able to benefit from economies of scale resulting in higher quality and lower cost. Contact with suppliers may be necessary if there is an emergency and parts cannot be produced in-house. Product Customer &D Design Manufacturing Marketing Distribution Service McGraw-Hill yerson Limited., 2004 p Part 3 The make or buy decision (Topic 9.3) Climate Control Inc. Exercise 12-3, page 598 requirement 1 First classify the costs: Direct materials Direct labour Variable manufacturing OH Fixed manufacturing OH salaries Fixed manufacturing OH equipment Fixed manufacturing OH common Cost of component from outside supplier elevant/ Irrelevant I I Stop the audio, turn to exercise 12-3, page 598 and the handout, page 2, then come back to listen to the solution. p

11 Part 3 The make or buy decision (Topic 9.3) Climate Control Inc. Exercise 12-3, page 598 requirement 1 Per unit Total-15,000 units Make Buy Make Buy Direct materials $6 Direct labour 8 Variable manufacturing OH 1 Fixed manufacturing salaries 2 Fixed manufacturing OH equipment -- Fixed manufacturing OH common -- TOTAL $17 Exclude irrelevant costs. p Part 3 The make or buy decision (Topic 9.3) Climate Control Inc. Exercise 12-3, page 598 requirement 1 Per unit Total-15,000 units Make Buy Make Buy Direct materials $6 Direct labour 8 Variable manufacturing OH 1 Fixed manufacturing salaries 2 Fixed manufacturing OH equipment -- Fixed manufacturing OH common -- Purchase price of components $20 TOTAL $17 $20 It will cost $3 per unit more to purchase the thermostats. p Part 3 The make or buy decision (Topic 9.3) Climate Control Inc. Exercise 12-3, page 598 requirement 1 Per unit Total-15,000 units Make Buy Make Buy Direct materials $6 $ 90,000 Direct labour 8 120,000 Variable manufacturing OH 1 15,000 Fixed manufacturing salaries 2 30,000 Fixed manufacturing OH equipment -- Fixed manufacturing OH common -- Purchase price of components $20 $300,000 TOTAL $17 $20$255,000 $300,000 A total difference of $45,000. p

12 Part 3 The make or buy decision (Topic 9.3) Climate Control Inc. Exercise 12-3, page 598 requirement 2 First classify the costs: Opportunity cost: segment margin foregone on a new product line elevant/ Irrelevant p Part 3 The make or buy decision (Topic 9.3) Climate Control Inc. Exercise 12-3, page 598 requirement 2 Total-15,000 units Make Buy Cost of making the part 255,000 Purchase price of components $300,000 Segment margin foregone 65,000 TOTAL $320,000 $300,000 A difference of $20,000 in favor of buying the new thermostat and implementing the new product line. p Part 3 Special orders (Topic 9.5) Prepare an analysis showing whether a special order should be accepted. (Level 1) Special order One-time order that is not considered part of the company s normal ongoing business. Only incremental costs are considered. Should not affect normal sales. Idle capacity should be available. p

13 Miyamoto Jewellers Exercise 12-4, page 598 Part 3 Special orders (Topic 9.5) First classify the costs: Materials Direct labour Fixed manufacturing OH Variable manufacturing OH Additional materials (for filigree) Cost of special tool elevant/ Irrelevant I Stop the audio, turn to exercise 12-4, page 598, and the handout, page 3 then come back to listen to the solution. p Miyamoto Jewellers Exercise 12-4, page 598 Part 3 Special orders (Topic 9.5) First classify the costs: Materials Direct labour Fixed manufacturing OH Variable manufacturing OH Additional materials (for filigree) Cost of special tool elevant/ Irrelevant I p Miyamoto Jewellers Exercise 12-4, page 598 Part 3 Special orders (Topic 9.5) Per bracelet 10 bracelets Incremental revenue ($ x 10) $ $3, Incremental cost Variable costs: Total variable cost Fixed costs: Total incremental cost Incremental operating income p

14 Miyamoto Jewellers Exercise 12-4, page 598 Part 3 Special orders (Topic 9.5) Per bracelet 10 bracelets Incremental revenue ($ x 10) $ $3, Incremental cost Variable costs: Materials ,430,00 Direct labour Variable manufacturing OH Additional materials (for filigree) Total variable cost $ $2, Fixed costs: Total incremental cost Incremental operating income p Miyamoto Jewellers Exercise 12-4, page 598 Part 3 Special orders (Topic 9.5) The special order adds $614,50 to the company s net operating income and should be accepted. Per bracelet 10 bracelets Incremental revenue ($ x 10) $ $3, Incremental cost Variable costs: Materials ,430,00 Direct labour Variable manufacturing OH Additional materials (for filigree) Total variable cost $ $2, Fixed costs: Fixed manufacturing OH - Cost of special tool Total incremental cost $2, Incremental operating income $ p MA1 MODULE 9 Part 4 Utilization of a constrained resource Topic

15 Part 4 Utilization of a constrained resource (Topic 9.6) Determine the most profitable utilization of scarce resources. (Level 1) Constraint A limitation under which a company must operate that restricts its ability to satisfy demand. i.e. a machine already operating 24/7 cannot produce any more units. When this constraint is narrowly focused it s called a bottleneck. How can a company maximize its profits under these conditions? Focus on maximizing total contribution margin. p Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 1 Product A B C Selling price $60 $90 $80 Less variable costs: Direct materials Direct labour Variable manufacturing OH Total variable cost Contribution margin $18 $36 $20 Maximize contribution margin when there is a constraint on direct labour: 3,000 hours at $8 per hour Stop the audio, turn to exercise 12-5, page 598 and the handout, page 4, then come back to listen to the solution. p Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 1 Product A B C Selling price $60 $90 $80 Less variable costs: Direct materials Direct labour Variable manufacturing OH Total variable cost Contribution margin $18 $36 $20 Amount of direct labour hours required Direct labour cost per unit/$8 Product A: $12/$8=1.5 hours Product B: $32/$8=4.0 hours Product C: $16$/8=2.0 hours p

16 Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 1 Product A B C Selling price $60 $90 $80 Less variable costs: Direct materials Direct labour Variable manufacturing OH Total variable cost Contribution margin $18 $36 $20 Amount of direct labour hours required Contribution margin per direct labour hour $12 $9 $10 Contribution margin per direct labour hour Product A: $18/1.5= $12/hour Product B: $36/4.0= $9/hour Product C: $20/2.0= $10/hour p Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 2 Product A B C Selling price $60 $90 $80 Less variable costs: Direct materials Direct labour Variable manufacturing OH Total variable cost Contribution margin $18 $36 $20 Contribution margin ratio 30% 40% 25% Amount of direct labour hours required Contribution margin per direct labour hour $12 $9 $10 Times 3,000 direct labour hours available 3,000 3,000 3,000 Total contribution margin $36,000 $27,000 $30,000 Focus production on product A. p Part 4 Utilization of a constrained resource (Topic 9.6) Utilizing constraints Focus on the constraint by relaxing (or elevating) it. Add more hours by paying overtime. Add another machine. Subcontract bottleneck processing. Move shift workers from a non-bottleneck process. Perform business process reengineering or total quality management techniques on the bottleneck process. educe defective units. How much would you be willing to pay to relax a constraint? Not more than the additional contribution margin will generate. p

17 Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 3 Product A B C Contribution margin $18 $36 $20 Amount of direct labour hours required Contribution margin per direct labour hour $12 $9 $10 Times 3,000 direct labour hours available 3,000 3,000 3,000 Total contribution margin $36,000 $27,000 $30,000 Up to how much should the company be willing to pay per hour in overtime wages if 3,000 additional hours are made available? p Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 3 Product A B C Contribution margin $18 $36 $20 Amount of direct labour hours required Contribution margin per direct labour hour $12 $9 $10 Times 3,000 direct labour hours available 3,000 3,000 3,000 Total contribution margin $36,000 $27,000 $30,000 Contribution margin per direct labour hour $12 Current direct labour rate 8 Maximum overtime rate: $20 They would be willing to pay an additional $12 per hour or $20 in total in overtime pay to produce Product A. p Part 4 Utilization of a constrained resource (Topic 9.6) Banner Company Exercise 12-5 page 598 requirement 3 Product A B C Contribution margin $18 $36 $20 Amount of direct labour hours required Contribution margin per direct labour hour $12 $9 $10 Times 3,000 direct labour hours available 3,000 3,000 3,000 Total contribution margin $36,000 $27,000 $30,000 Contribution margin per direct labour hour $12 $9 $10 Current direct labour rate Maximum overtime rate: $20 $17 $18 They would be willing to spend up to $17 in overtime pay for product B and up to $18 in overtime for product C. p

18 MA1 MODULE 9 Part 5 Joint product costs and the contribution approach Topic Part 5 Joint product costs and the contribution approach (Topic 9.7) Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. (Level 1) Joint product costs Cream aw milk Purchasing and separating Skim Split-off point Joint products p Part 5 Joint product costs and the contribution approach (Topic 9.7) Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. (Level 1) aw milk Joint product costs Purchasing and separating $30,000 Split-off point Sales value Cream $28,000 10,000 litres Skim $22,000 30,000 litres Joint products How are the costs of the raw milk and the further processing allocated to cream and liquid milk? 1. Based on relative sales value. 2. Based on physical measure. Stop the audio, turn to the handout, page 5, then come back to listen to the solution. p

19 Part 5 Joint product costs and the contribution approach (Topic 9.7) Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. (Level 1) Based on relative sales value Cream Skim Total Sales value $28,000 $22,000 $50,000 % of total 56% 44% 100% Allocate $30,000 processing costs $16,800 $13,200 $30,000 Contribution margin $11,200 $8,800 $20,000 p Part 5 Joint product costs and the contribution approach (Topic 9.7) Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. (Level 1) Based on relative sales value Cream Skim Total Sales value $28,000 $22,000 $50,000 % of total 56% 44% 100% Allocate $30,000 processing costs $16,800 $13,200 $30,000 Contribution margin $11,200 $8,800 $20,000 Based on physical measure Litres 10,000 30,000 40,000 % of total 25% 75% 100% Allocate $30,000 processing costs $7,500 $22,500 $30,000 Contribution margin $20,500 ($500) $20,000 p Part 5 Joint product costs and the contribution approach (Topic 9.7) Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. (Level 1) Joint product costs Separate product costs aw milk Purchasing and separating Split-off point Cream Skim Joint products Manufacture ice cream Pasteurize homogenize and bottle Ice cream Packaged skim milk p

20 Part 5 Joint product costs and the contribution approach (Topic 9.7) Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. (Level 1) Sell or process further decision. aw milk Purchasing and separating Cream Skim Manufacture ice cream Pasteurize homogenize and bottle Ice cream Packaged skim milk Joint products p Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Input Stop the audio, turn to exercise 12-6 page 599, and the handout, page 6, then come back to listen to the solution. p Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Joint product costs X $50,000 Input Processing $100,000 Y $90,000 Split-off point Z $60,000 Joint products p

21 Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Joint product Separate costs product costs New Additional product X X processing $80,000 $50,000 $35,000 Input Processing $100,000 Split-off point Y $90,000 Z $60,000 Joint products Additional processing $40,000 Additional processing $12,000 New product Y $150,000 New product Z $75,000 p Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Joint product Separate costs product costs New Additional product X X processing $80,000 $50,000 $35,000 Input Processing $100,000 Split-off point Y $90,000 Z $60,000 Joint products Additional processing $40,000 Additional processing $12,000 New product Y $150,000 New product Z $75,000 p Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Classify the costs: Joint processing costs Further processing costs elevant/ Irrelevant I p

22 Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Product X Y Z Sales value after further processing $80,000 $150,000 $75,000 Sales value at split-off point 50,000 90,000 60,000 Incremental revenue 30,000 60,000 15,000 Cost of further processing Incremental profit/loss p Part 5 Joint product costs and the contribution Solex Company approach (Topic 9.7) Exercise 12-6, page 599 Product X Y Z Sales value after further processing $80,000 $150,000 $75,000 Sales value at split-off point 50,000 90,000 60,000 Incremental revenue 30,000 60,000 15,000 Cost of further processing 35,000 40,000 12,000 Incremental profit/loss ($5,000) $20,000 $3,000 Sell product X at split-off and process product Y and Z further. p Part 5 Joint product costs and the contribution approach (Topic 9.7) Joint product costs W X By-products: Joint product with a relatively low sales value. (wood chips, molasses) Input Processing Y Z Split-off point Joint products 66 22

23 MA1 MODULE 9 Part 6 Economic order quantity (EOQ) and the reorder point Topic Part 6 Economic order quantity (EOQ) and the reorder Compute the optimum inventory level and order size. (Level 1) Ordering cost Clerical costs Transportation costs Carrying cost Storage space costs Handling costs Property taxes Insurance Obsolescence losses Interest on capital invested in inventory Inventory Costs eading Part 6 Economic order quantity (EOQ) and the reorder Compute the optimum inventory level and order size. (Level 1) Ordering cost Clerical costs Transportation costs Carrying cost Storage space costs Handling costs Property taxes Insurance Obsolescence losses Interest on capital invested in inventory Inventory Costs Costs of not carrying sufficient inventory (stock outs) Customer ill will Quantity discounts forgone Erratic production Inefficiency of production runs Added transportation charges eading 9-1 Lost sales 69 23

24 Part 6 Economic order quantity (EOQ) and the reorder Compute the optimum inventory level and order size. (Level 1) ABC analysis Inventory Control Break inventory items into three categories based on value. Control is focused on A items which have the highest value and are usually the smallest in number. Economic order quantity Determining an order size that minimizes costs of ordering and carrying inventory. eading Part 6 Economic order quantity (EOQ) and the reorder Economic order quantity Total cost Annual carrying cost: C Annual ordering cost: P Exhibit 13-9, eading 9-1, CGA lesson notes, module 9 eading Part 6 Economic order quantity (EOQ) and the reorder Economic order quantity EOQ Total cost is minimized (reading 9-1 page 2) Exhibit 13-9, eading 9-1, CGA lesson notes, module 9 eading

25 Part 6 Economic order quantity (EOQ) and the reorder Economic order quantity formula E = order size in units Q = annual quantity used in units P = cost of placing an order C = annual cost of carrying one unit in stock eading Part 6 Economic order quantity (EOQ) and the reorder Economic order quantity formula E =? Q = 3,000 P = $10 C = $.80 eading Part 6 Economic order quantity (EOQ) and the reorder Total annual cost T = P(Q/E)+C(E/2) Order cost Carrying cost E = order size in units Q = annual quantity used in units P = cost of placing an order C = annual cost of carrying one unit in stock eading

26 Part 6 Economic order quantity (EOQ) and the reorder Total annual cost T = P(Q/E)+C(E/2) Order cost Carrying cost T = P(Q/E) + C(E/2) =$10(3,000/274) + $.80*(274/2) = $109 + $110 = $219 eading Part 6 Economic order quantity (EOQ) and the reorder Economic order quantity formula for production O O = optimal production lot size Q = annual production quantity P = setup costs for each run C = annual cost of carrying one unit in stock eading Part 6 Economic order quantity (EOQ) and the reorder Bakerview products sells 24,000 units of the Deluxe-2M each year. The inventory control manager is concerned about rising costs and wants to determine the economic order quantity. After doing some research, the manager has determined the following costs: Cost to place an order $25 Cost to carry one Deluxe-2M in inventory for 1 year $2 What is the EOQ for the Deluxe-2M? Stop the audio, turn to the handout, page 7, then come back to listen to the solution. eading

27 Part 6 Economic order quantity (EOQ) and the reorder Bakerview products sells 24,000 units of the Deluxe-2M each year. The inventory control manager is concerned about rising costs and wants to determine the economic order quantity. After doing some research, the manager has determined the following costs: Cost to place an order $25 Cost to carry one Deluxe-2M in inventory for 1 year $2 What is the EOQ for the Deluxe-2M? = 775 units per order Handout, page 7 eading Part 6 Economic order quantity (EOQ) and the reorder Bakerview products sells 24,000 units of the Deluxe-2M each year. The inventory control manager is concerned about rising costs and wants to determine the economic order quantity. After doing some research, the manager has determined the following costs: Cost to place an order $25 Cost to carry one Deluxe-2M in inventory for 1 year $2 What is the total annual cost for Deluxe-2M? T = P ( Q / E) + C( E / 2) T=25(24,000/775) + 2(775/2) T = $1,549 per year Handout, page 7 eading Part 6 Economic order quantity (EOQ) and the reorder Bakerview products sells 24,000 units of the Deluxe-2M each year. The inventory control manager is concerned about rising costs and wants to determine the economic order quantity. After doing some research, the manager has determined the following costs: Cost to place an order $35 Cost to carry one Deluxe-2M in inventory for 1 year $2 What will happen to EOQ if ordering costs increase to $35 per order? = 917 units per order Handout, page 7 eading

28 Part 6 Economic order quantity (EOQ) and the reorder Bakerview products sells 24,000 units of the Deluxe-2M each year. The inventory control manager is concerned about rising costs and wants to determine the economic order quantity. After doing some research, the manager has determined the following costs: Cost to place an order $25 Cost to carry one Deluxe-2M in inventory for 1 year $2.50 What will happen to EOQ if carrying costs increase to $2.50 per unit? = 693 units per order Handout, page 7 eading Part 6 Economic order quantity (EOQ) and the reorder Summary of requirements Order cost Annual carrying cost/unit EOQ Original costs $25 $ Increased order costs $35 $ Increased carrying costs $25 $ As order costs increase, EOQ increases. The manager will want to order larger quantities resulting in fewer orders As carrying costs increase, EOQ decreases. The manager will want to order smaller quantities, resulting in less storage and handling. eading Part 6 Economic order quantity (EOQ) and the reorder JIT focuses on reducing the order cost (P). eading

29 Inventory(units) Inventory(units) Part 6 Economic order quantity (EOQ) and the reorder eorder point Time when an order is placed to replenish stock. = (lead time x average demand) + safety stock Lead time Time between order and receipt of stock. Safety stock Additional units kept on hand to satisfy maximum demand that can be reasonably expected during the lead time. eading Part 6 Economic order quantity (EOQ) and the reorder Average usage Time (weeks) EOQ Safety stock Adapted from Exhibit 13-10, eading 9-2, CGA lesson notes, module 9 eading Part 6 Economic order quantity (EOQ) and the reorder Average usage Time (weeks) EOQ Safety stock Maximum expected usage Adapted from Exhibit 13-10, eading 9-2, CGA lesson notes, module 9 eading

30 Inventory(units) Part 6 Economic order quantity (EOQ) and the reorder eorder point Safety stock Average usage Time (weeks) Lead time EOQ Maximum expected usage Adapted from Exhibit 13-10, eading 9-2, CGA lesson notes, module 9 eading Part 6 Economic order quantity (EOQ) and the reorder Aegean distributors, sells building materials throughout western Canada. The following information relates to a line of metal doors carried by the company: Economic order quantity Lead time Average weekly usage 650 units 4 weeks 65 units What is the reorder point? (assuming no safety stock) = (lead time x average demand) + safety stock = ( 4 weeks x 65 ) + 0 = = 260 units Stop the audio, turn to the handout, page 8, then come back to listen to the solution. eading Part 6 Economic order quantity (EOQ) and the reorder Aegean distributors, sells building materials throughout western Canada. The following information relates to a line of metal doors carried by the company (Handout, page 8): Economic order quantity 650 units Lead time 4 weeks Average weekly usage 65 units Maximum weekly usage 78 units What is the reorder point? (with safety stock) Safety stock is additional stock required to satisfy maximum demand during the lead time. Maximum weekly usage 78 units Average weekly usage 65 units Safety stock 13 units Lead time x 4 weeks Safety stock 52 units eading

31 Part 6 Economic order quantity (EOQ) and the reorder Aegean distributors, sells building materials throughout western Canada. The following information relates to a line of metal doors carried by the company: Economic order quantity Lead time Average weekly usage Maximum weekly usage 650 units 4 weeks 65 units 78 units What is the reorder point? (with safety stock) = (lead time x average demand) + safety stock = ( 4 weeks x 65 ) + 52 = = 312 units Handout, page 8 eading MA1 MODULE 9 Part 7 eview question: elevant cost analysis (download the additional questions handout: ma1_mod9_handout1.pdf) 92 Part 7 eview question: elevant cost analysis Problem pages Handout pages 9 and Would the increased fixed expenses be justified? 2. Compute the per unit break-even price on this order. 3. What unit cost figure is relevant for setting a minimum selling price? 4. What would be the impact on profits of closing the plant for the two-month period? 5. Compute the unit cost figure that is relevant for comparison to the quoted price. Stop the audio, read and attempt the question in the textbook then come back to listen to the solution

32 Part 7 eview question: elevant cost analysis Problem pages Handout pages 9 and Would the increased fixed expenses be justified? 2. Compute the per unit break-even price on this order. 3. What unit cost figure is relevant for setting a minimum selling price? 4. What would be the impact on profits of closing the plant for the two-month period? 5. Compute the unit cost figure that is relevant for comparison to the quoted price. 94 Part 7 eview question: elevant cost analysis Problem pages Handout pages 9 and Would the increased fixed expenses be justified? 2. Compute the per unit break-even price on this order. 3. What unit cost figure is relevant for setting a minimum selling price? 4. What would be the impact on profits of closing the plant for the two-month period? 5. Compute the unit cost figure that is relevant for comparison to the quoted price. 95 MA1 MODULE 9 Part 8 eview questions: etain or drop a department Make or buy decision Special order/make or buy (download the additional questions handout: ma1_mod9_handout1.pdf) 96 32

33 Part 8 eview question: etain or drop a department; make or buy decision; special order Past CGA exam question Handout page 11 Prepare an analysis to determine whether the shoe department should be dropped, and make a recommendation. Stop the audio, read and attempt the question in the handout then come back to listen to the solution. 97 Part 8 eview question: etain or drop a department; make or buy decision; special order Past CGA exam question Handout page 12 State whether Green s should make or buy the game boards from the competitor. Stop the audio, read and attempt the question in the handout then come back to listen to the solution. 98 Part 8 eview question: etain or drop a department; make or buy decision; special order Past CGA exam question Handout pages a. Should the government agency contract be accepted? b. Should the contractor s offer be accepted? Stop the audio, read and attempt the question in the handout then come back to listen to the solution

34 MA1 MODULE 9 Part 9 eview question: EOQ and safety stock (download the additional questions handout: ma1_mod9_handout1.pdf) 100 Part 9 eview question: EOQ and safety stock Handout question Handout pages Compute the EOQ. 2. At 18% risk of a stock out what would be the safety stock? The reorder point? 3. At 6% risk of a stock out what would be the safety stock? The reorder point? Stop the audio, read and attempt the question in the handout then come back to listen to the solution. 101 Part 9 eview question: EOQ and safety stock Handout question Handout pages At a 6% stock out risk what would be the total cost of ordering and carrying inventory for one year? 5. a) Using a JIT purchasing policy compute the new EOQ. b) How frequently would the company be placing an order?

35 MA1 MODULE 9 Part 10 eview questions: Multiple Choice Questions (download the additional questions handout: ma1_mod9_handout1.pdf) 103 Part 10 eview questions: Multiple choice Multiple choice questions Handout pages 17 thru 19 Now working on page 17 Q1 What is the affect of the decision on EOQ? Q2 If the division were discontinued how much would IPM s income increase? Q3 What is the EOQ for Popcorn Co? Q4 Which would not be relevant to the closure decision? Stop the audio, read and attempt the question in the handout then come back to listen to the solution. 104 Part 10 eview questions: Multiple choice Multiple choice questions Handout pages 17 thru 19 Now working on page 18 Q5 What type of cost is machine amortization? Q6 Which is not a relevant cost? Q7 Which is the appropriate decision and related cost?

36 Part 10 eview questions: Multiple choice Multiple choice questions Handout pages 17 thru 19 Now working on page 19 Q8 How many units of the standard and deluxe models should be produced? Q9 What should be considered when deciding whether to accept or reject the order?