Short-Run Decision Making:
Relevant Costing and Inventory Management
Learning Objectives
1.
Describe the short-run decision-making model and explain how cost behavior affects the information used to make decisions.
2. Apply relevant costing and decision-making concepts in a variety of business situations.
3. Choose the optimal product mix when faced with one constrained resource.
4. Explain the impact of cost on pricing decisions.
5. Discuss inventory management under the economic order quantity and JIT models.
1. SHORT-RUN DECISION MAKING
Short-run decision making involves choosing among alternatives and tends to be short-run in nature with an immediate end in view.
Sound short-run decision making results in decisions that achieve an immediate objective and serve the overall strategic goals of the organization.
A. The Decision-Making Model
The six steps in the decision making process are as follows:
1. Define the problem.
2. Identify alternatives as possible solutions to the problem; eliminate alternatives that are not feasible.
3. Identify the relevant costs and benefits associated with each feasible alternative; eliminate irrelevant costs and benefits from consideration.
4. Total the relevant costs and benefits for each alternative.
5. Assess qualitative factors.
6. Select the alternative with the greatest overall benefit.
B. Ethics in Decision Making
In tactical decision making, ethical concerns relate to the way in which decisions are implemented and the possible sacrifice of long-run objectives for short-run gain.
Objectives should be attained within an ethical framework and be consistent with the company’s missions and goals.
C. Relevant Costs Defined
Relevant costs:
- are future costs, and
- differ among the alternatives.
An irrelevant cost can be:
- a past cost, or
- a future cost that does not differ among the alternatives being considered.
A sunk cost is a cost for which the outlay has already been made.Sunk costs are the result of past decisions and cannot be changed by current or future action. The acquisition cost of equipment purchased in the past is a sunk cost. After sunk costs are incurred, they are unavoidable. Since sunk costs are past costs that do not differ among the alternatives, sunk costs are irrelevant costs.
2. SOME COMMON RELEVANT COST APPLICATIONS
We all are aware of the need of quantitative numbers to make decisions, but there is a need to examine qualitative factors. Many times it is difficult to quantify qualitative factors, such as quality of materials, late orders, customer relations, and so on. Qualitative factors are very important when making decisions.
There are four major types of relevant costing decisions mentioned in this section: make or buy, keep or drop, special order, and sell or process further. Cornerstones can be used to illustrate each of the decision types.
Cornerstone 12-1: How to Structure a Make-or-Buy Problem
- See Mowen and Hansen text for demo problems.
Cornerstone 12-2: How to Structure a Special-Order Problem
- See Mowen and Hansen text for demo problems.
Cornerstone 12-3: How to Structure a Keep-or-Drop Product Line Problem
See Mowen and Hansen text for demo problems.
Cornerstone 12-4: How to Structure a Keep-or-Drop Product Line Problem with Complementary Effects
- See Mowen and Hansen text for demo problems.
Cornerstone 12-5: How to Structure the Sell-or-Process-Further Decision
- See Mowen and Hansen text for demo problems.
3. PRODUCT MIX DECISIONS
In some cases product resources, such as materials, labor, or equipment, may be limited.
Constraints are limitations due to limited resources or limited product demand. A manager must choose the optimal mix given the firm’s constraints.
A. One Constrained Resource
When there is one scarce resource, determine which product results in the highest contribution margin per unit of the scarce resource.
For example, if the scarce resource is machine hours, for each product calculate the contribution margin per machine hour as follows:
The quantity needed of the product with the highest contribution margin per machine hour should be produced before producing the other products.
Cornerstone 12-6: How to Determine the Optimal Product Mix with One Constrained Resource
- See Mowen and Hansen text for demo problems.
Cornerstone 12-7: How to Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint
- See Mowen and Hansen text for demo problems.
B. Multiple Constrained Resources
When more than one resource is limited, linear programming can be used to determine the optimal solution.
4. PRICING DECISIONS
Two approaches to pricing:
1. Cost-based pricin g—Cost-based pricing uses a markup, or percentage applied to the base price, to determine the selling price.
2. Target costing and pricin g—Target costing determines the cost of a product or service based on the price (target price) that customers are willing to pay. The marketing department deter mines what characteristics and price for the product are acceptable to customers, then engineers design and develop the product so that cost and profit can be covered by that price.
Cornerstone 12-8: How to Calculate Price by Applying a Markup Percentage to Cost
- See Mowen and Hansen text for demo problems.
Cornerstone 12-9: How to Calculate a Target Cost
- See Mowen and Hansen text for demo problems.
5. DECISION MAKING FOR INVENTORY MANAGEMENT
A. Inventory-Related Costs
Ordering costs are the costs of placing and receiving an order. Examples include the clerical costs of processing an order, the cost of insurance for shipment, and unloading costs.
Setup costs are the costs of preparing equipment and facilities for production. Examples include wages of idled production workers, lost income from idled production facilities, and the costs of test runs (labor, materials, and overhead).
Carrying costs are the costs of carrying inventory, such as storage and handling costs, the opportunity cost of funds invested in inventory, and insurance and taxes on the inventory.
Since both ordering costs and setup costs are costs of acquiring inventory, they are treated in the same manner.
Stockout costs are the costs associated with having insufficient amounts of inventory. Stockout costs include:
lost sales (both current and future)
costs of expediting (overtime or increased transportation costs)
costs of interrupted production
B. Traditional Reasons for Holding Inventory
Traditional reasons for holding inventories are:
to balance ordering or setup costs and carrying costs
to satisfy customer demand (meet delivery dates)
to avoid shutting down manufacturing facilities due to machine failure, defective or unavailable parts, and/or late delivery of parts.
to buffer against unreliable production processes
to take advantage of discounts
to hedge against future price increases
C. Economic Order Quantity: The Traditional Inventory Model
An inventory policy addresses two questions:
How much inventory should be ordered (or produced)?
When should the order be placed (or the setup performed)?
Order Quantity and Total Ordering and Carrying Costs
The order quantity used should minimize the total cost of ordering and carrying inventory.
Total inventory-related costs = Ordering cost + Carrying cost
= P D /Q + C Q /2
- where:
P = the cost of placing and receiving an order (or the setup cost for a production run)
- D = the known annual demand
- Q = quantity (the number of units ordered each time an order is placed or the lot size for a production run)
- C = the cost of carrying one unit of stock for one year
The economic order quantity is the order quantity that minimizes the total cost.
Cornerstone 12-10: How to Calculate Ordering Cost, Carrying Cost, and Total Inventory-Related Cost
- See Mowen and Hansen text for demo problems.
D. Computing EOQ
The economic order quantity is calculated as:
The EOQ is the order size that results in ordering costs equaling carrying costs.
The economic order quantity model can also be used to determine the most economical size of a production run. The only difference is that setup costs for starting a production run are substituted for ordering costs.
Cornerstone 12-11: How to Calculate the EOQ, Ordering Cost, Carrying Cost, and Total Inventory-Related Cost
- See Mowen and Hansen text for demo problems.
E. EOQ and Inventory Management
The traditional approach to inventory management is called a just-in-case system.
The traditional manufacturing environment uses mass production of a few standardized products that typically have a very high setup cost. The high setup cost encourages a large batch size and long production runs. Diversity is viewed as being costly and is avoided.
F. Just-In-Time Approach to Inventory Management
Competitive pressures have led many firms to abandon the EOQ model in favor of a just-in-time (JIT) approach to manufacturing and purchasing. JIT offers increased cost efficiency and simultaneously has the flexibility to respond to customer demands for better quality and more variety.
G. Basic Features of JIT
JIT (just-in-time) manufacturing is a demand-pull system. Products are produced only when demanded by customers.
JIT purchasing occurs when parts and materials arrive just in time to be used in production.
Differences between JIT and traditional manufacturing are summarized below:
System: |
- pull-through system based on demand
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Inventory
effects: |
- suppliers deliver parts just in time to be used in production
- uses a few suppliers with long-term contracts
|
- higher levels of inventory than JIT
- inventory used as a buffer because of delayed reaction time
- greater number of suppliers with short-term contracts
|
Plant layout: |
- manufacturing cells consist of a set
of machines that produce a particular product or product family
- multiskilled labor where workers are trained to operate all machines within
the cell
- requires less space and reduces lead times
|
- departmental structure with machines performing similar functions are located together in a department
- specialized labor where workers operate a specific machine
|
Grouping of
employees: |
- service departments providing support services, such as materials stores, are reassigned to work with manufacturing cells
- cell workers perform more of support services, such as setup and preventive maintenance
|
- service departments providing support services are centralized
- a central stores location handles materials
- a central purchasing department places all purchase orders for materials
|
Employee
empowerment: |
- increased employee participation, which increases productivity and cost efficiency
- input from employees is sought
- managers act as facilitators to develop people and skills
|
- less participation by employees in management of organization
- managers act as supervisors
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Total quality
control: |
- poor quality cannot be tolerated without inventories
- quest for defective-free products
|
- acceptable quality level (AQL) permits defects to occur as long as they do not exceed a certain level
|
Traceability of
overhead costs: |
- uses more direct tracing of overhead costs and less driver tracing and allocation
- use of manufacturing cells results in more costs being directly traceable to products
|
- relies more on driver tracing and allocation
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H. Setup and Carrying Costs: The JIT Approach
The traditional approach takes setup costs as given and then tries to minimize total carrying costs and setup costs.
JIT attempts to reduce setup costs (or ordering costs) by:
reducing the time it takes to set up for production, and
reducing the number of orders through long-term contracting.
If setup and ordering costs are insignificant, the only remaining cost to minimize is carrying cost, which is minimized by reducing inventories to insignificant levels.
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