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Chapter 13

“ Inventory Model “

Dr . Mohamed Mousa
Inventory Types :
 Inventory includes the raw materials,
work-in-process, and finished goods that a
company has on hand for its own
production processes or for sale to
 Inventory is considered an asset, so the
accountant must consistently use a valid
method for assigning costs to inventory in
order to record it as an asset.
Dr . Mohamed Mousa
Inventory Types :
The valuation of inventory is not a minor
issue, because the accounting method used
to create a valuation has a direct bearing on
the amount of expense charged to the cost
of goods sold in an accounting period, and
therefore on the amount of income earned.
The basic formula for determining the cost
of goods sold in an accounting period is:
Cost of goods sold = Beginning inventory +
Purchases - Ending inventory
Dr . Mohamed Mousa
Inventory Cost

There are 4 policy will result in using either

the specific identification method, the first in
first out method (FIFO), the last in first out
method (LIFO), or the weighted average

Dr . Mohamed Mousa
1-Specific Identification Method :
When you buy inventory from suppliers, the
price tends to change over time, so you end
up with a group of the same item in stock,
but with some units costing more than
others. As you sell items from stock, you
have to decide on a policy of whether to
charge items to the cost of goods sold that
were presumably bought first, or bought
last, or based on an average of the costs of
all items in stock.
Dr . Mohamed Mousa
2- First in First out Method :

First in, first out method. Under the FIFO

method, you are assuming that items bought
first are also used or sold first, which also
means that the items still in stock are the
newest ones.

Dr . Mohamed Mousa
3- Last in First out Method :
Last in, first out method. Under the LIFO
method, you are assuming that items bought
last are sold first, which also means that the
items still in stock are the oldest ones. This
policy does not follow the natural flow of
inventory in most companies; in fact, the
method is banned under International
Financial Reporting Standards.

Dr . Mohamed Mousa
4- Weighted Average Method :
Weighted average method. Under the
weighted average method, there is only one
inventory layer, since the cost of any new
inventory purchases are rolled into the cost
of any existing inventory to derive a new
weighted average cost, which in turn is
adjusted again as more inventory is

Dr . Mohamed Mousa
Inventory Decision Questions :
 How much to order ?
When to order ?
The basis of The inventory model is the
following generic cost function :
Total inventory cost = Purchasing cost + setup
cost + Holding cost + shortage cost

Dr . Mohamed Mousa
Inventory Decision Questions :
Purchasing cost :is the price per unit of an
inventory item . At times the item is offered
at a discount if the order size exceeds a
certain amount , which is a factor in
deciding how much to order.
 setup cost :Represents the fixed charge
incurred when an order ( no matter the size)
is placed.

Dr . Mohamed Mousa
Inventory Decision Questions :
 Holding cost : Represents the cost of
maintaining inventory in stock . It includes
the interest on capital and cost of storage ,
maintenance , and handling.
 shortage cost : is the penalty incurred when
stock is out . It includes potential loss of
income , disruption in production , and the
subjective cost of loss in customer`s good
will .

Dr . Mohamed Mousa
Order qty, Q
Inventory Level

Reorder point, R

0 Lead Lead Time

time time
Order Order Order Order
Placed Received Placed Received

The EOQ Model Cost Curves :
Slope = 0
Total Cost
cost ($)

total cost
Holding Cost = HQ/2

Ordering Cost = SD/Q

Optimal order Q* Order Quantity, Q

EOQ Cost Model :

D : demand rate
2 KD
K : setup cost Y 

h : Holding cost h
Y : order quantity

T0 : Ordering cycle length

R & B beverage company has a soft drink product that
has a constant annual demand rate of 100 unit per day
it costs $ 100 to initiate a purchase order . R & B
plant kept in storage is estimated to cost about $ . 2
per day . The lead time between placing and
Receiving an order is 12 days .

Determine the optimal inventory level for ordering the

units ?


D : demand rate = 100 units per day

K : setup cost = $ 100 per order
h : Holding cost = $ 0. 2 per unit / day
L : Lead time = 12 days
Y : order quantity ?

Dr . Mohamed Mousa 1-16


2KD 2 * $100 *100

Y 
Y 

h 0.2

T0 : Ordering cycle length = y* / D = 1000 / 100 = 10 Days

Le : effective lead time= L - T0 = 12 – 10 = 2 Days

Le D = 2 Days * 100 unit per day = 200 unit

Dr . Mohamed Mousa 1-17


Reorder point = 200 units

The inventory policy is order 1000 units
whenever the inventory level drops to 200 units
 TCU(y) = K / (Y/D) + h * (Y/2)

= $100/(1000/100)+$0.0 2(1000/2) = $ 20 per day

Dr . Mohamed Mousa 1-18

The Next Lecture

Chapter 13
Inventory models

Dr . Mohamed Mousa 1-19