Inventory Management
Type of companies
Merchandising Companies – Inventory – Finished goods
Manufacturing companies- Inventory – Raw materials- WIP and Finished goods
Service Companies
Intangible inventories consisting of cost incurred on behalf of clients but not
billed.
Matching Cost with revenues
Gross Profit = Net sales – Cost of Good sold
Cost of Good sold = Cost of goods available for sale – ending inventory
What happens when
Ending Inventory Increases – Profit Increases
Ending Inventory Decreases – Profit Decreases
Inventory valuation affects both statement of Profit and loss and balance sheet
Example
Quantity Price purchase price
100 1.01 101
80 1.1 88
90 1.3 117
Goods available for sale 306
Ending Inventory = 120 units Cost of Good sold
Value of this ending inventory A B C
Goods available for sale 306 306 306
120 units * 1.01 = 121
120 units*1.10 = 132 Less EI 121 132 156
120 units * 1.30 =156
Cost of goods sold 185 174 150
Effect of Inventory error
It is self reversing in nature
A manager who overvalues the ending inventory can report higher profit in
the current year, but It will bring down the profit in the following year.
Process
Acquisition cost Measurement Inventory Recording in
Problem Costing methods balance sheet
• Includes all • Periodic • Specific • Lower the
costs related method Identification cost or
to the • Perpetual method market value
purchases method • Average cost
• FIFO
• LIFO
Net Purchase Cost
· Cost of merchandise, and
· Expenditures necessary to make goods
ready for use:
· Freight (i.e., freight-in).
· Handling, processing , assembling, etc.
· Adjust for returns and allowances.
· Adjust for cash (purchase) discounts from
supplier.
· NOTE: Record purchases when received
(i.e., title transfers) not when ordered. 6-8
Measurement Issue
Goods available for sale (i.e., beginning inventory plus purchases).
How much becomes cost of goods sold?
How much becomes ending inventory?
Two approaches:
1. Periodic inventory method.
2. Perpetual inventory method.
6-9
Measurement Issues
Periodic Inventory Method
Physical count is made
Physicalcounting shows the cost of merchandise
remaining at the end of the period
Perpetual Inventory method
Record in maintained for each item purchased and sold
When sale is made, cost of goods sold is immediately
updated.
6-10
Continous record keeping
Periodic vs. Perpetual
· Periodic method.
· Less recordkeeping.
· Perpetual method.
· Detailed record is useful for reordering.
· Built in check (i.e., identifies shrinkage by inventory item during physical
inventory).
· Income statement can be prepared without taking a physical inventory.
6-11
Inventory Costing methods
Specific Identification Method
Average Cost method
FIFO ( First in First out method
LIFO ( Last in First out method)
Specific Identification Method
It is a common practice at Big ticket items, jewelry paintings and custom
made furniture's
Bar codes and scanners are making it feasible with lower cost items
13
Example
Consider 150 units of watches sold
100 units are purchased at Rs.4000 per unit
50 units were purchased at Rs. 5000 per unit. What is the cost of goods sold?
Cost of goods sold ( cost prices * no of units sold)
Sales ( cost prices + profit margin = selling price * units sold)
150 units of watches
(100 *4000) +(50 *5000) =650000
14
Average Cost Method
Where cost of goods sold and ending inventory are costed at its average cost
Average cost from previous example ( one unit of each item )
(4000+5000)/2= 4500 per unit
15
First in First out method
FIFO assumes the oldest goods are sold first and most recently purchased are
ending inventory
16
Example
Unit Unit price Total Cost
Beginning inventory 150 14 2100
Purchases 200 15 3000
Purchases 350 17 5950
Purchases 200 (-100) 18 3600
Purchases 100 20 2000
Available for sale 1000 16650
Sold 800
Ending Inventory 200 units
FIFO Ending inventory Ending inventory _ LIFO
100 *20 = 2000 150*14 =2100
100 *18= 1800 = 3800 50*15= 750 = 2850 17
Last in first out
Cost of goods sold is based on the cost of the most recent purchases and
ending inventory is costed at the cost of oldest units available
Sell the latest goods and keep the one;s which I bought first as ending
inventory
18
IFRS rule
LIFO is not permitted under IFRS
LIFO Reserve
IF the companies determine the inventory by LIFO method.
The companies need to estimate using FIFO or average cost
Report the difference between the LIFO and any one of the other inventory
methods and report them as LIFO RESERVE
LIFO reserve is just the mathematical difference and is only disclosed in their
financial statements.
19
Lower of cost or Market value
In an ordinary situation, inventory is reported at its cost
It is reduced below cost only when there is evidence that the value of items
when eventually sold or disposed off or physical deterioration or obsolence or
other causes
Lower the cost or market value
20
Lower of cost or Market value
Market value : Current replacement cost
It should not be higher than the estimated selling price of the items less the
cost associated with selling it. Net Realizable value
It should not be lower that the NRV less normal profit margin
21
Lower of Cost or market
General inventory valuation principle deriving from conservatism concept,
inventory need to reported on the balance sheet at the lower of its cost or its
market value
Accounting and Research Bulletin says
Inventory should be valued at current replacement cost
It should not be higher the estimated selling price ( net realizable value)
It should not be lower the net realizable value less normal profit margin
General use : USE THE HISTORICAL COST IF IT IS LOWEST or use next to the
lowest of the other three possibilities
22
