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5. Inventory Management Page 1
5. Inventory Management
Objectives
As we’ve learned in many of our school of lean courses, managing inventory is an extremely important activity for any organization practicing lean. As such, in this module we’re going to begin our exploration of inventory management. Specifically, by the end of this module you’ll understand the problems of using a traditional, standard cost approach to inventory valuation including the impact overproduction can have when traditional cost accounting is performed.
Inventory Management Basics Inventory incudes raw materials, finished goods, and work in process. And all types of inventory must be accounted for on the balance sheet. Additionally, the change in the amount of inventory is accounted for on a profit & loss or income statement. The value of finished goods inventory includes the cost of the raw materials, as well as the conversion costs, such as direct labor and overhead, to convert the raw materials into finished product. Finished goods inventory is also considered an asset because the product will eventually be sold and the costs will hopefully be recovered plus a profit.
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Standard Costing OK, now that we’ve covered those basic concepts, let’s talk more specifically about how inventory is managed using standard costing. Standard costing starts with budgeting, an often-‐onerous process of collecting estimates from sales, production, and the supporting departments throughout the organization. This information is then used to estimate annual use of raw materials, labor, and manufacturing overhead. Budgeted numbers are compared to actual numbers and the differences, called variances, are noted as either positive or negative.
Comparing estimates to actual costs requires detailed tracking and complicated, often hard to understand, variances. Furthermore, in traditional accounting, “actual” numbers often include many underlying assumptions that may create errors. For example, the cost of quality in a specific product may be based on an assumption that
“15% of overall quality labor is dedicated to that particular product.” When total QA costs are tallied at the end of the month, 15% of that number is then imputed into the “actual” product cost, whether or not that 15% happened to be accurate for that month. This creates potentially erroneous decisions about cost. And many organizations spend hours upon hours dissecting these costs, when the potential error created by the underlying assumptions swamps the size of the other individual costs they’re trying to understand. Organizations can have hundreds, even thousands, of transactions that need to be tracked… as such, one objective of Lean Accounting is to radically reduce the number of transactions, which we’ll get back to later in this module. Next, tracking budgets and variances, often by department, also encourages silo thinking and anti-‐lean behaviors such as buying raw materials in bulk simply to get a discount and building finished goods inventory in order to absorb manufacturing overhead. Now, let’s look at a simple example where overproducing actually looks good on the traditional books, and then, when the extra inventory is sold off and maintained at a level more closely aligned with customer demand, which happens early in a learn journey, the financials actually look worse using standard cost. For this example, this company planned to make 100 units per month with an estimated $1,000 of fixed manufacturing overhead per month resulting in the standard cost of $10 overhead per unit. We’d also like to note the standard variable costs for materials and labor were $5 and $3 respectively. For this first month we’ll assume there’s no existing inventory and the company produced 120 units,
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which was 20 more units than planned, and sold 90 units. Now let’s add these numbers to the income statement and balance sheet.
Since we made 120 units and each unit absorbs $10 of manufacturing overhead, we’ve absorbed $1,200 of manufacturing overhead for the month. Our estimated overhead absorption was $1,000 based on our plan to produce 100 units for the month. So, we absorbed more overhead than we planned which makes the cost of goods sold for the month go down which is shown as a positive volume variance – a variance of the fixed overhead cost that’s attributed to a larger volume of production. To clarify, the $200 represents a favorable reduction in cost of goods sold. At this point, if we sold nothing for the month we’d have 120 units in inventory on the balance sheet, which, at standard cost have a value of $2,160 and we’ve made $200 in gross profit because we lowered the costs of goods sold by $200 on the income statement. To clarify, we arrived at this gross profit figure since zero minus negative two hundred equals positive two hundred. Now, when we account for what we sold that same month the standard costs tied to the finished goods sold move from the balance sheet to the income statement. And, as mentioned earlier, we did sell 90 units, so let’s see how that changes the numbers.
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When the standard costs for 90 units sold are moved over to the income statement, 30 units remain on the balance sheet as finished goods and we end up with $830 of gross profit, which is a 37% gross profit percentage margin, and $540 of assets, the standard costs for 30 units, in inventory. In other words, we made a good profit and we have assets. Things actually look good even though we produced more than we estimated and more than the customer purchased. As a result, these so-‐called “good” results might reinforce the non-‐lean approach of buying more raw materials than we need while also creating more finished goods inventory than our customers have requested. But once an organization starts practicing lean it will seek to drastically reduce waste, including the waste of inventory, and it will need to “burn off” excess inventory until it more closely aligns with customer demand. Continuing with our prior example, let’s say the organization decides to get serious about lean and it decides it’s ready to reduce inventory in month 2 of our example. Based on standard costs, overhead is tied to a planned production of 100 units. But remember, there are still 30 units in finished goods from last month’s overproduction so production was purposely slowed down because they planned to sell some finished goods from inventory. In fact, they sold 105 units in month 2. The finished goods inventory is carried over from last month, so we start with 30 units of inventory at a value of $540. Since 80 units were produced this month and each unit absorbs $10 of manufacturing overhead, only
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$800 of manufacturing overhead was absorbed for the month. Our estimated overhead absorption was $1,000 based on our plan to produce 100 units for the month. So, we absorbed less overhead than we planned, which makes the cost of goods sold for the month go up and is shown as a negative volume variance – a variance of the fixed overhead cost that’s attributed to a lower volume of production.
At this point, if we sold nothing for the month we’d have 110 units in inventory on the balance sheet, which, at standard cost, have a value of $1,980, and we’ve lost $200 in gross profit because we increased the costs of goods sold by $200 since 0 minus $200 equals negative $200 on the income statement.
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When the standard costs for 105 units sold are moved over to the income statement we end up with $535 of gross profit, which is a 20% gross profit percentage margin, and we have $90 of assets, which is the standard costs for 5 units, in inventory. We still have a profit.
Things look good even though we produced more than we estimated and more than the customer purchased. Now, believe it or not, this was a simple example, yet the numbers definitely got complicated and hard to follow. What we didn’t include were the several types of variances that are applied to costs of goods sold that make it even more complicated to understand the meaning behind the profit or loss in a given month. Also, we only showed two months, but what if raw materials and finished goods were in inventory over several months. It gets even more difficult for the purchasing department and production managers to determine how much to order or make. We also made the assumption that Finished Goods inventory sold for the original price of $25/unit. As we’ve discussed in the Seven Deadly Wastes course, inventory can become outdated and raw material prices may have changed, requiring even more analysis by lots, and the use of First In First Out or Last In First Out inventory methods. If we’re being honest, unnecessary inventory creates a lot of needless complexity, which is one reason why lean seeks to minimize inventory wherever possible.
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So, let’s summarize the results from these two months.
In month 1, where we actually overproduced by 20 units, our gross profit was $830 or 37% and our assets were valued at $540. Then, in month 2, where we decided to practice lean thinking and produce less in order to consume some of the excess inventory, our gross profit dropped to $535, or 20% and our assets reduced in value to $90. And when we examine the differences between these two months things don’t seem to be headed in the right direction! Put another way, all of this lean thinking didn’t seem to yield the results our financial team was looking for! All joking aside, it’s this exact scenario that could stop your early lean efforts dead in their tracks which, as it turns out, almost happened to our friends over at Treetop Incorporated when they first started on their lean journey which is exactly what we’ll discuss in our next module… so we’ll speak to you soon!