Slide 1

Welcome to lecture 7.
Slide 2
The topic for this week is inventories
Slide 3
In this first video, we are going to cover the first four learning outcomes being know the
definition of inventory, know the importance of inventory, understand risks of inventory, and
know how to value inventory.
Slide 4
Inventory are raw materials, work-in-process goods and completely finished goods that are
considered to be the portion of a business's assets that are ready or will be ready for sale
Inventory process is one of the major process in any business because the turnover of inventory
represents one of the primary sources of revenue generation and subsequent earnings for the
company's shareholders/owners
Inventories are also known as Goods or stock
Slide 5
Inventory is very important for manufacturing firms, however it can be costly to maintain
It also carries significant amount of risks but represents an important part of profit calculation
Slide 6
Inventory can be categorized into 3; raw materials, work in process, and finishes goods.
Raw materials are materials and components scheduled for use in making a product.
Work in process, WIP – are materials and components that have begun their transformation to
finished goods
Finished goods are goods ready for sale to customers
Slide 7
Lets look at some reasons why firms would want to hold inventory. Basically this has four major
reasons
First is time; The time lags present in the supply chain, from supplier to user at every stage, requires
that you maintain certain amounts of inventory to use in this lead time. However, in practice, inventory
is to be maintained for consumption during 'variations in lead time'. Lead time itself can be addressed by
ordering that many days in advance.
Second is Uncertainty that is inventories are maintained as buffers to meet uncertainties in
demand, supply and movements of goods.
Third to achieve economies of scale - Ideal condition of "one unit at a time at a place where a
user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So
bulk buying, movement and storing brings in economies of scale
Fourth is appreciation in Value. In some situations, some stock gains the required value when it
is kept for some time to allow it reach the desired standard for consumption, or for production.
For example; beer in the brewing industry
Slide 8
How much inventory to hold is a big question that businesses need to address because
(i) Possessing a high amount of inventory for long periods of time is not usually good for
a business because of inventory storage, obsolescence and spoilage costs
(ii) possessing too little inventory isn't good either, because the business runs the risk of
losing out on potential sales and potential market share as well.

Slide 9
So some methods to manage inventory levels include Economic order quantity (EOQ). EOQ is
the order quantity that minimizes total inventory holding costs and ordering costs. It is one of
the oldest classical production scheduling models
Second is Just in Time (JIT) which is a production strategy that strives to improve a business'
return on investment by reducing in-process inventory and associated carrying costs
Slide 10
The balance for inventory is calculated as beginning inventory + net purchases – cost of goods
sold. So that formula will give us the value for ending inventory.
In other words, you take what the company has in the beginning, add what it has purchased,
subtract what's been sold, and the result is what remains.
Slide 11
Inventory should never be valued at more than its net realizable value, which equals its
expected sales price minus any associated selling expenses
For example, if a storm damages a car that cost an automobile dealer $25,000, and if the car
can now be sold for no more than $23,000. Then the value of the car must be reported at
$23,000. This decrease in the value of inventory is recognized by debiting the loss on inventory
write‐down account, which is an expense account, and by crediting inventory
Slide 12
Stock taking is counting of inventory and it is very important to do this at year end to determine
inventory that is on hand.
Stock counting is a good control for businesses since this process will determine the exact
amount of stock on hand at that point in time
This can be compared with the company’s records and then we can actually determine the
amount of inventory loss, shortage, or any theft during that period
We call this as inventory discrepancies. In performing these counting procedures the businesses
can also identifying obsolete, excess and slow-moving items
Businesses can check for correct quantity and price for the goods in order to ensure that
inventory is valued appropriately at the lower of cost and net realizable value.
Slide 13
Stock taking involves seven steps. First is inventory ticketing, second counting, third we have to
recount, fourth examining, fifth collecting, sixth costing and then finally ending inventory
amount.
Slide 14
Step 1 starts with the inventory ticketing process where inventory items are tagged with their
descriptions and then stock is counted in step 2.
In step 3, stock is re-counted for verification purposes and then in step 4, inventory records are
examined and updated in the stock sheets
In step 5, all inventories examined are collected and collated together for costing purposes in
step 6.
It is important to note that IFRS provides choices for inventory valuation methods. So there are
4 costing methods for inventory systems: first-in first-out method; last-in first-out method,
weighted average method and specific identification method. Also at this stage, it is necessary
to value inventories either using a lower of cost or net realizable value rule. Whichever, costing
system provides lower value will be accounted for in the balance sheet as closing stock
Finally, in step 7, inventory details are processed and updated in the accounting system.
Slide 15
When we have FOB Shipping point the supplier is responsible up until the point of shipping and
the buyer is responsible for the goods in transit and the buyer will pay the freight
Whereas in FOS destination the supplier is responsible for the goods until they reach their
destination, supplier is responsible for goods in transit and the supplier pays the freight
Slide 16
Lets look at the impact on the underlying profit of the company.
Sales less the cost of goods sold will give me gross profit.
Costs of goods sold or cost of sales are beginning inventory + purchases of inventory less ending
inventory.
If you overstate the ending inventory then gross profit will be overstated and if you understate
the ending inventory then gross profit will be understated.
Slide 17
The accounting method that a company decides to use to determine its inventory costs can
directly impact the balance sheet, income statement and statement of cash flow. Three
inventory-costing methods are widely used by both public and private companies
First-In, First-Out (FIFO) so this method assumes that the first unit making its way into inventory
is the first sold. For example, let's say that a bakery produces 200 loaves of bread on Monday at
a cost of $1 each, and 200 more on Tuesday at $1.25 each. FIFO states that if the bakery sold
200 loaves on Wednesday, the COGS is $1 per loaf (recorded on the income statement)
because that was the cost of each of the first loaves in inventory. The $1.25 loaves would be
allocated to ending inventory (appears on the balance sheet).
Last-In, First-Out (LIFO) so this method assumes that the last unit making its way into inventory
is sold first. The older inventory, therefore, is left over at the end of the accounting period. For
the 200 loaves sold on Wednesday, the same bakery would assign $1.25 per loaf to COGS, while
the remaining $1 loaves would be used to calculate the value of inventory at the end of the
period.
Average Cost so this method is quite straightforward; it takes the weighted average of all units
available for sale during the accounting period and then uses that average cost to determine
the value of COGS and ending inventory. In our bakery example, the average cost for inventory
would be $1.125 per unit, calculated as [(200 x $1) + (200 x $1.25)]/400.
Slide 18
If inflation was not present, then all three of the inventory valuation methods would produce
the exact same results. When prices are stable, our bakery would be able to produce all of its
bread loaves at $1, and FIFO, LIFO and average cost would give us a cost of $1 per loaf.
Unfortunately, the world is more complicated. Over the long term, prices tend to rise, which
means the choice of accounting method can dramatically affect valuation ratios.
Lets assume the prices are rising, so because of this rising prices FIFO gives us a better indication
of the value of ending inventory (on the balance sheet), but it also increases net income because
inventory that might be several years old is used to value the cost of goods sold. Increasing net income
sounds good, but remember that it also has the potential to increase the amount of taxes that a
company must pay.

LIFO isn't a good indicator of ending inventory value because the leftover inventory might be
extremely old and, perhaps, obsolete. This results in a valuation much lower than today's
prices. LIFO results in lower net income because cost of goods sold is higher
Average cost produces results that fall somewhere between FIFO and LIFO.
Slide 19
Inventory management is a science primarily about specifying the shape and percentage of
stocked goods. It is required at different locations within a facility or within many locations of a
supply network to precede the regular and planned course of production and stock of
materials.
Slide 20
Inventory appears as a current asset on an organization's balance sheet because the
organization can, in principle, turn it into cash by selling it. Some organizations hold larger
inventories than their operations require in order to inflate their apparent asset value and their
perceived profitability.
In addition to the money tied up by acquiring inventory, inventory also brings associated costs
for warehouse space, for utilities, and for insurance to cover staff to handle and protect it from
fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Such holding
costs can mount up: between a third and a half of its acquisition value per year.
Businesses that stock too little inventory cannot take advantage of large orders from customers
if they cannot deliver. The conflicting objectives of cost control and customer service often pit
an organization's financial and operating managers against its sales and marketing
departments. Salespeople, in particular, often receive sales-commission payments, so
unavailable goods may reduce their potential personal income. This conflict can be minimized
by reducing production time to being near or less than customers' expected delivery time.