To increase the percentage of net income of revenue, an organization has to manage its inventory by effectively managing the cost of purchasing, ordering, carrying, stock outs, cost of other quality related specifications and shrinkage. These costs must be relevant in decision making which means the change only occurs in consisting with the number of orders placed. While doing so, there are several decisions have to be made. First decision is how much to order with the help of The Economic order quantity (EOQ) model.
There are certain assumptions in EOQ model like demand; ordering and carrying costs are constant without any stock out. The second decision is when to order a given product with the consideration of order lead time and certainty of products sold. But in case of uncertainty of demand a safety stock is kept to act as a buffer in lead times. One conflict in EOQ is the opportunity cost of carrying unnecessary inventories which could create more costs for the company. For this reason, companies are moving toward JIT purchasing to reduce cost.
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In contrast with EOQ, Just in time (JIT) purchasing is a method used to decrease the carrying cost of the inventory and the cost of placing the order through different ways. It builds long-term supplier relationship, which in turn cuts down the ordering cost by reducing price negotiation time. It also helps in reducing the carrying cost by receiving goods only when they are needed. The success of JIT largely depends on how a company plans, coordinates and controls its supply chain based on customer demand pattern. It is quite a challenge because a Supply Chain Management can reduce stock outs.
Excess inventories leads to higher costs but there are also several other problems which arise like trust, incompatible information system and limited resources. Other type of inventory management is MRP, a push approach. MRP manufactures finished goods according to the final products demand forecasts, bill of materials and the quantities of input needed. A cause of failure of MRP is not recording and updating inventory costs. There is particular time and amount of finished goods to be produced in MRP. While in JIT production, goods are produced only when needed by the next process or stage of production.
This system achieves the close coordination between workstations in order to smooth the flow of goods throughout the production line to meet customers demand and reduce the total costs. Different from MRP, JIT production has some particular features. It organizes the production lines in cells which reduces the handling time and cost. Workers are trained to perform minor maintenance. Lead time is minimized due to setup time being reduced and allows companies to meet the changing demands. Certain suppliers are chosen to deliver the best quality goods on the production floor.
Enterprise resource planning is a system which increases the flow of information that helps in the succession of JIT. It is a customized, integrated set of software system that feeds all data into a single database in order to provide quick access and reduce redundancy. ERP allows lower-level managers, workers, customers, and suppliers access to operating information on time to smooth the processes and save cost. With the uniqueness of every organization, for an ERP to be useful, it must be customized for each company. Under JIT, overhead costs are reduced and some indirect costs can be classified as directed.
For this reason, some companies also adopt similar, simplified JIT methods like backflush costing and lean accounting. Backflush omits some journal entries from purchase of direct materials to the sale of finished good without losing much information. This method is not adhered to GAAP and leaves no audit trails. However, it allows managers to keep track of operations by personal observations and nonfinancial measures. Unlike backflush costing, lean accounting focuses on the value streams, not individual products or department.
It traces actual costs directly to the value streams and ignores variance and standard costs. Unused facility costs are treated as expenses in order to create the visibility of waste resources and incentives to reduce these costs. Like backflush costing, lean accounting is simpler to apply and it helps in reducing unused resources. But it also limits its usefulness in decision making by ignoring the individual product costs, making the value stream look profitable without the consideration of all costs and ignores GAAP during the process.
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