Unit 4

INVENTORY EVALUATION
INTRODUCTION

Inventories generally form one of the largest items in the current assets of the
companies. Inventory valuation is crucial to income measurement and inventory
management is crucial to financial management. Inventory is tangible property to
be consumed in production of goods or services or held for sale in the ordinary
course of business. Inventories are unconsumed or unsold goods purchased or
manufactured.

According to Accounting Standard (AS) – 2(Revised) Inventories are “assets:

a) Held for sale in the ordinary course of business;
b) In the process of production for such sale; or
c) In the form of materials or supplies to be consumed in the production process
or in in the rendering of services.

There are three basic types of inventory:

1) Raw Materials —raw materials inventory is made up of goods that will
be used in the production of finished products, e.g., nuts, bolts, flour,
sugar.
2) Work in Process —work in process inventory, or WIP, consists of
materials entered into the production process but not yet completed, e.g.,
subassemblies.
3) Finished Goods —finished goods inventory includes completed
products waiting to be sold, e.g., bar stools, bread, cookies.

 Manufacturing concern - inventory consists of all of the above 3

components
 Trading concern -inventory consists of finished goods

Objectives of Inventory Valuation

The two objectives to be achieved by proper valuation of inventories are-
1) Determination of Income - We know that opening and closing stock affect
the quantum of Gross Profit (and hence net profit) of any concern. Any
improper valuation of closing stock (i.e. inventory) will lead to over and
under statement of Gross profits of not only this year but also next year
(as closing stock of this year becomes the opening stock of next year).
2) Determination of Financial position-Inventory appears as current asset in
the balance sheet. Any improper valuation will lead to distortion in the
balance sheet also. Besides these, inventory is use for computing various
ratios which are used by proper valuation cannot be over-emphasised.

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Effect of an inventory error on profit
 An error in the value of the year-end inventory will distort:
i. cost of goods sold,
ii. gross profit,
iii. net profit, current assets, and
iv. equity.
 Overvaluation of closing stock leads to :
i. Overstatement of current year profits and
ii. Understatement of profits of succeeding years and vice-versa.

The principal systems for determining physical quantities and valuation of

inventory. There are two methods of taking inventories ( types of Inventory
recording system)
1. Periodic Inventory Method;
2. Perpetual Inventory Method.

Periodic inventory system

With the periodic inventory system, acquisition and reduction of inventory are not
recorded in the inventory account. Instead, all inventory acquisition is recorded in
purchase account. When inventory is sold or used, the cost of goods is usually
unknown. At the end of accounting period a physical count of inventory is taken
and cost is assigned to the good on hand. Cost of goods sold or used is
calculated deducting the balance on hand from the amount of goods
available ( opening inventory plus purchases) during the period. This can
only be done base on the some cost flow assumption such as FIFO,LIFO and
VACO. With the prices of goods changing the accounting, different cost flow
assumption result in different cost of goods sold and ending inventory evaluation.

Also known as “Annual Stock Taking”. Quantity and value of inventory

determined only at the end of the accounting period after taking a physical count
of the inventory.
Cost of goods sold (COGS) is a residual figure and is obtained as follows:

COGS = Opening stock + total purchases - closing stock

Advantage
 It is simple to understand
Drawbacks
 Quantity and value of inventory not known on a continuous basis.
 No accounting is done for shrinkage, losses, theft, and wastage –
Assumes materials not in stock have been used.

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Perpetual inventory system

In a perpetual inventory system, the inventory account contains current records

of all inventory transaction. A perpetual inventory system allows the firm to
charge inventory costs to production or cost of good sold as soon as inventory is
used. Each acquisition of raw material and each transfer of inventory to work in
process are recorded in the inventory account as it occurs.

Records the balance of inventory after every receipt and issue to facilitate regular
checking and to avoid closing down the firm for stock-taking. Also known as
continuous inventory system Records the balance of inventory after every receipt
and issue to facilitate regular checking and to avoid closing down the firm for
stock-taking There is continuous physical stock-taking throughout the year and
physical stocks are verified and compared with the balances recorded in stock
registers (bin cards and stores
Ledger).

The closing inventory is calculated as a residual figure, ascertained as

follows:
Closing Stock = Opening Stock + Purchases– Cost of goods sold.

Advantages
 Helps in preparation of Interim financial statements.
 Regular checking and rigid control:
o Reduces the possibility of loss, theft, stock shortages
o Helps in identification of slow moving and obsolete stock
 Avoids the suspension of business for stock taking as physical stocks can
be counted whenever desired.

Drawback
 Elaborate system - more expensive.

INVENTORY VALUATION AND MATCHING PRINCIPLE

According to Matching principle, the expenses during an accounting period
should match the income earned during the accounting period. Since goods are
continuously bought and sold, the amount of inventories that should be carried
forward to the next accounting
period should be determined so that the current years revenue is matched with
the current years cost of goods sold.

Cost of Goods sold = Opening stock + Purchases+ Direct Expenses –

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Closing stock

THERE ARE THREE METHODS USED WHEN VALUING THE GOODS THAT
YOU HAVE ON HAND

First-In, First-Out (FIFO)

This method is based on the premise that the first inventory purchased is the first
to be sold. The remaining assets in inventory are matched to the assets that are
most recently purchased or produced. It is one of the most common methods of
inventory valuation used by businesses as it is simple and easy to understand.
During inflation, the FIFO method yields a higher value of the ending inventory,
lower cost of goods sold, and a higher gross profit. Unfortunately, the FIFO
model fails to present an accurate depiction of the costs when there is a rapid
hike in prices. Also, unlike the LIFO method, it does not offer any tax advantages.

Last-In, First-Out (LIFO)

Under this inventory valuation method, the assumption is that the newer
inventory is sold first while the older inventory remains in stock. This method is
hardly used by businesses since the older inventories are rarely sold and
gradually lose their value. This results in significant loss to the business.The only
reason to use LIFO is when businesses expect the inventory cost to increase
over time and lead to a price inflation. By moving high-cost inventories to cost of
goods sold, the reported profit levels businesses can be lowered. This allows
businesses to pay less tax.

Weighted Average Cost

Under the weighted average cost method, the weighted average is used to
determine the amount that goes into the cost of goods sold and inventory.
Weighted average cost per unit is calculated as follows:

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This method is commonly used to determine a cost for units that are
indistinguishable from one another and it is difficult to track the individual costs.
Choosing the right inventory valuation method is important as it has a direct
impact on the business’s profit margin. Your choice can lead to drastic
differences in the cost of goods sold, net income and ending inventory.

To assess the method which is best for business , they need to pay attention to
changes in the inventory costs.

 If the inventory costs are escalating or are likely to increase, LIFO costing
may be better. As higher cost items are considered sold, it results in
higher costs and lower profits.
 In case your inventory costs are falling, FIFO might be the best option for
the business.
 For a more accurate cost, use the FIFO method of inventory valuation as it
assumes the older items that are less costly are the ones sold first.

As a business owner, you need to analyze each method and apply the method
that reflects the periodic income accurately and suits the specific business
situation. The Financial Accounting Standards Board (FASB), in its Generally
Accepted Accounting Procedures, allows both FIFO and LIFO accounting.It is
also important to note businesses cannot switch from one method of inventory
valuation to another.

Methods Advantages Disadvantages

FIFO Permitted by accounting standards as an Requires care to get it right
acceptableapproach to inventory valuation.
Closing inventory has a value close to its
replacement value
Might reflect physical use of stock
LIFO Inventory is issued at close to its current cost Not permitted as a stock valuation
(significant if there is high inflation of volatile method under financial reporting

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 stock prices) standards
Might reflect physical use of stock. Requires care to get it right
AVCO Averages out stock price fluctuations.
Relatively easy to work out.
Permitted by Financial reporting Standards.

EXAMPLE

Use the following information to calculate the value of inventory on hand on Mar
31 and cost of goods sold during March in FIFO periodic inventory system and
under FIFO perpetual inventory system.

Mar 1 Beginning Inventory 68 units @ $15.00 per unit

5 Purchase 140 units @ $15.50 per unit
9 Sale 94 units @ $19.00 per unit
11 Purchase 40 units @ $16.00 per unit
16 Purchase 78 units @ $16.50 per unit
20 Sale 116 units @ $19.50 per unit
29 Sale 62 units @ $21.00 per unit

Use LIFO on the following information to calculate the value of ending inventory
and the cost of goods sold of March.

Mar 1 Beginning Inventory 60 units @ $15.00

5 Purchase 140 units @ $15.50
14 Sale 190 units @ $19.00
27 Purchase 70 units @ $16.00
29 Sale 30 units @ $19.50

Solution

Apply AVCO method of inventory valuation on the following information, first in

periodic inventory system and then in perpetual inventory system to determine
the value of inventory on hand on Mar 31 and cost of goods sold during March.

Mar 1 Beginning Inventory 60 units @ $15.00 per unit

5 Purchase 140 units @ $15.50 per unit
14 Sale 190 units @ $19.00 per unit
27 Purchase 70 units @ $16.00 per unit
29 Sale 30 units @ $19.50 per unit

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QUESTION 1
Oshana mini Market had a stock of 20 crates (a crate has 24 bottles) of soft
drinks (nips) at the beginning of June. This opening stock was purchased at
N$7.00 per bottle. In the succeeding days, Beverage manager made the
following additional purchases during the same month of June.
o 8 June 50 crates @ N$8.00 per bottle.
o 20 June, 120 crates @ N$8.50 per bottle.
o 25 June, 140 crates @ N$8.75 per bottle.

At close of business on 30 June, Oshana mini market had a stock of 45 crates.

Required:
Calculate Oshana mini market `s cost of good sold and closing stock for the
month of june using:
i. FIFO (4 Marks)
ii. LIFO (5 Marks)
iii. ACM (5 Mark

INVENTORY CONTROL (INVENTORY MANAGEMENT)

Inventory management includes planning, coordinating, and controlling activities
related to the flow of inventory into, through, and out of an organization.
Customers usually perceive quality service, as availability of goods when they
want them Inventory must be sufficient to provide high quality customer service.

There are many approaches in practice to ordering goods from suppliers. In this
chapter we will consider one particular approach – that of ordering fixed
quantities each time.

Supposed:
If a company needs a total of 12,000 units each year, then they could decide to
Order 1,000 units to be delivered 12 times a year. Alternatively, they could order
6,000 units to be delivered 2 times a year. There are obviously many possible
order quantities.

First we will consider the costs involved and thus decide on the order quantity
that minimizes these costs (the economic order quantity).

Costs involved
The costs involved in inventory ordering systems are as follows:
๏ the purchase cost

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๏ the reorder cost
๏ the inventory-holding cost

Purchase cost
This is the cost of actually purchasing the goods. Over a year the total cost will
remain constant regardless of how we decide to have the items delivered and is
therefore irrelevant to our decision. (Unless we are able to receive discounts for
placing large orders – this will be discussed later in this chapter).

Re-order cost
This is the cost of actually placing orders. It includes such costs as the
administrative time in placing an order, and the delivery cost charged for each
order. If there is a fixed amount payable on each order then higher order
quantities will result in fewer orders needed over a year and therefore a lower
total reorder cost over a year.

Inventory holding cost

This is the cost of holding items in inventory. It includes costs such as
warehousing space and insurance and also the interest cost of money tied up in
inventory. Higher order quantities will result in higher average inventory levels in
the warehouse and therefore higher inventory holding costs over a year.

Need to hold inventories

The questions of managing inventories arise only when the company holds
inventories. Maintaining inventories involves tying up of the company’s funds and
storage and handling costs. If it is expensive to maintain inventories, why do the
companies hold inventories? There are three general motives for holding
inventories.

1. The transactions motive that emphasizes the need to maintain inventories

to facilitate smooth production and sales operations.
2. The precautionary motive, which necessitates holding of inventories to
guard against the risk of unpredictable change in demand and supply
forces and other factors.
3. The speculative motive which influences the decision to increase or
reduce inventory levels or of take advantage of price fluctuations.

Other objects of inventory management

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The objectives of inventory control are:

 To minimize the possibility of delay in production through regular

supply of raw materials, stores and spares, tools and other equipment and
when required.
 To avoid unnecessary capital locked up in inventories, and
 To exercise economies in ordering, the obtaining and storing of materials.

To manage inventories efficiently and effectively answer should be sought

to the following two questions: How much should be ordered? When should it
beordered?

1. The first question, how much to order, relates to the problem of determining
economic order quantity (EOQ) and is answered with an analysis of the cost
maintaining certain level of inventories. The second question, when to
order, arises because of uncertainty and is a problem of determining
the recorder point.

Minimizing costs
One obvious approach to finding the economic order quantity is to calculate the
costs p.a. for various order quantities and identify the order quantity that gives
the minimum total cost.

Example 1
Janis has demand for 40,000 desks p.a. and the purchase price of each desk is
$25. There are ordering costs of $20 for each order placed. Inventory holding
costs amount to 10% p.a. of inventory value.
Calculate the inventory costs p.a. for the following order quantities, and
plot them on a graph:

(a) 500 units

(b) 750 units
(c) 1,000 units
(d) 1,250 units

A more accurate and timesaving way to find the EOQ is to use the formula . The
economic order quantity (EOQ) is a model that is used to calculate the optimal
quantity that can be purchased or produced to minimize the cost of both the
carrying inventory and the processing of purchase orders or production set-ups.
In other word is the ordering size for an item of inventory that results in the
lowest total inventory cost for the period. The total inventory cost consists

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of ordering cost and carrying cost. As the name suggests,

The full equation is:

EOQ = √(2SD / H), or the square root of (2 x S x D / H).

S = Setup costs (per order, generally includes shipping and handling)

D = Demand rate (quantity sold per year)

H = Holding costs (per year, per unit)

EOQ applies only when demand for a product is constant over the year and each
new order is delivered in full when inventory reaches zero. There is a fixed cost
for each order placed, regardless of the number of units ordered. There is also a
cost for each unit held in storage, commonly known as holding cost, sometimes
expressed as a percentage of the purchase cost of the item.

The economic order quantity is computed by both manufacturing companies and

merchandising companies. Manufacturing companies compute it to find the
optimal order size of raw materials inventory and

merchandising companies compute it to find the optimal order size of ready to

use merchandise inventory.

The ordering and holding costs

The two significant factors that are considered while determining the economic
order quantity (EOQ) for any business are the ordering costs and the holding
costs.

Ordering costs

The ordering costs are the costs that are incurred every time an order for
inventory is placed with the supplier. Examples of these costs include telephone
charges, delivery charges, invoice verification expenses and payment processing
expenses etc. The total ordering cost usually varies according to the frequency of
placing orders. Mostly, it is directly proportional to the number of orders placed
during the year which means If the number of orders placed during the year
increases, the annual ordering cost will also increase and if, on the other hand,
the number of orders placed during the year decreases, the annual ordering cost
will also decrease.

Holding costs

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The holding costs (also known as carrying costs) are the costs that are incurred
to hold the inventory in a store or warehouse. Examples of costs associated with
holding of inventory include occupancy of storage space, rent, shrinkage,
deterioration, obsolescence, insurance and property tax etc. The total holding
cost usually depends upon the size of the order placed for inventory. Mostly, the
larger the order size, the higher the annual holding cost and vice versa. The total
holding cost is some time expressed as a percentage of total investment in
inventory.

Economic order quantity (EOQ) model is the method that provides the
company with an order quantity. This order quantity figure is where the record
holding costs and ordering costs are minimized. By using this model, the
companies can minimize the costs associated with the ordering and inventory
holding. In 1913, Ford W. Harris developed this formula whereas R. H. Wilson is
given credit for the application and in-depth analysis on this model.

The formula is:

EOQ =√ 2CoD
CH

2 is constant
Where Co = fixed costs per order
D = total demand per year
CH = the inventory holding cost per unit per annum

Basic EOQ Assumptions

 There are only ordering and carrying costs.

 The same quantity is ordered at each reorder point.
 Demand, purchase-order lead time, ordering costs, and carrying costs are
known with certainty.
 Purchasing costs per unit are unaffected by the quantity ordered.
(Therefore, purchasing costs are irrelevant.)
 No stockouts occur.

How EOQ Works

The Principles Behind EOQ: The Total Cost Curve

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  Keeping inventory on hand
 Interest
 Insurance
 Taxes
 Theft
 Obsolescence
 Storage Costs

Ordering and Carrying Costs Illustrated

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Example 2
For the information given in Example 1,
(a) Use the EOQ formula to calculate the Economic Order Quantity.
(b) Calculate the total inventory costs for this order quantity.

2.2 Quantity discounts

Often, discounts will be offered for ordering in large quantities. The problem may
be solved using the following steps:
1. Calculate EOQ ignoring discounts
2. If it is below the quantity, which must be ordered to obtain, discounts,
calculate total annual inventory costs.
3. Recalculate total annual inventory costs using the order size required to
just obtain the discount
4. Compare the cost of step 2 and 3 with the saving from the discount and
select the minimum cost alternative.
5. Repeat for all discount levels

Example 3
For the information given in Example 1 the supplier now offers us discounts on
purchase price as follows:

Order quantity discount

0 to < 5,000 0%
5,000 to < 10,000 1%
10,000 or over 1.5 %

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Re-order level and ‘safety’ inventories

In the previous paragraphs we have considered the re-order quantities for

inventory - that is the quantity that we should order each time.
However, in real life, it is unlikely that the supplier will deliver our order instantly –
for example, it might take a week for the delivery to arrive - and therefore we
need to place an order when we still have some units left. If we do not have
sufficient units in inventory to last us until the delivery arrives, then we will run out
of inventory and have to turn customers away. The time between the placing of
an order and the delivery arriving is known as the lead time.
The level of inventory at which time we should place a new order is known as
the re-orderlevel.

Reorder level
The EOQ model helps management decide how much to order at a time. Another
important decision is when to order. This decision depends on the Lead time,
which is the length of time it take material to be receive after an order is
placed. By placing an order to avoid a stockout management take account
of the potential cost of shortages. The reorder point or reorder level is a stock
balance when a new purchase order should be issued to replenish inventory
stock. In other words, it is the amount of inventory to be used during the lead
time when stock will be replenished.

Formula
The formula to compute reorder point varies depending on the inventory’s
consumption rate and amount of safety stock. In case of an inventory’s constant
usage rate, the equation is as follows:

If a company doesn’t maintain safety stock:

Reorder Point = Daily Average Usage × Lead Time in Days
If a company maintains safety stock:
Reorder Point = Daily Average Usage × Lead Time in Days + Safety Stock
If an inventory’s usage rate is irregular and there isn’t any safety stock, the daily
maximum usage should be used instead of the daily average usage.
Reorder Point = Daily Maximum Usage × Lead Time in Days

Ordering Points Illustrated

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Safety Stock (demand and lead time uncertain)

 Safety stock is inventory held at all times regardless of the quantity of

inventory ordered using the EOQ model.
 Safety stock is a shield against unexpected increases in demand,
uncertainty about lead time, and unavailability of stock from
suppliers.
 Managers use a frequency distribution based on prior daily or
weekly levels of demand to compute safety-stock levels.

Example 4
A company has a demand from customers of 100 units per week.
The time between placing an order and receiving the goods (the lead time) is 5
weeks. What should the re-order level be? (i.e. how many units should we still
have in inventory when we place an order).

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Example 5
A company has a demand from customers of 100 units per week. The time
between placing an order and receiving the goods (the lead time) is 5 weeks.
The company has a policy of holding safety inventory of 100 units. What should
the re-order level be?

In practice, the demand per day and the lead time are unlikely to be certain.
What therefore we might do is re-order when we have more than 500 units in
inventory, just to be ‘safe’ in case the demand over the lead time is more than
500 units. Any extra held in inventory for this reason is known as safety
inventory, or buffer inventory.

Example 6
Demand from customers is uncertain and is between 70 and 120 units per week.
The lead time is also uncertain and is between 3 and 4 weeks. What should the
re-order level be if we are to never run out of inventory?

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