Introduction to Cost & Management Accounting ACCT 1003(MS 15B)

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UNIVERSITY OF WEST INDIES OPEN CAMPUS Introduction to Cost & Management Accounting ACCT 1003(MS 15B) INVENTORY VALUATION INVENTORY VALUATION & CONTROL At the end of an accounting period,

1 UNIVERSITY OF WEST INDIES OPEN CAMPUS Introduction to Cost & Management Accounting ACCT 1003(MS 15B) INVENTORY VALUATION INVENTORY VALUATION & CONTROL At the end of an accounting period, inventory/stock must be counted and its value determined or verified. A company s ending inventory must be reported accurately. An error in the ending inventory will affect the current year s income statement, statement of owner s equity and balance sheet. Closing inventory for one accounting period is the opening inventory for the next accounting period; hence the following year s financials would also be affected. Observing and verifying ending inventory is an important aspect of the external auditors job The method used to value inventory is dependent upon the policy and conditions of the business and is determined by management. Types of Inventory Systems There are two types of inventory systems Perpetual Inventory System Periodic Inventory system The Perpetual Inventory System Merchandising transactions are recorded as they occur. Each time an addition to inventory is made by purchasing, or in some other way such as sales returns, the amount is added to inventory and each time a reduction is made through sale, purchase returns or any other reason the total amount of inventory is decreased. This means that COGS and inventory are continually updated each time merchandise is purchased/added or sold/subtracted - POS system. A running balance is maintained of inventory remaining after each receipt or issue of inventory. Used mainly by large businesses that is computerized e.g. large supermarkets and department stores. Almost all manufacturing companies also utilize a POS system, as these businesses need current information to coordinate their inventories of raw materials with their production schedule. The balance on COGS and inventory accounts are always current. Freight-in or carriage inwards is added to the cost of inventory. Stock taking is done at year end to verify the balance of inventory on the books. Adjustment would be made to COGS and Inventory for any shortage or inventory shrinkage resulting from pilferage, spoilage or shoplifting. These systems are quite expensive however, which limits their use to very large businesses. Periodic Inventory system Used primarily in small businesses with manual accounting systems No effort is made to keep up-to-date records Unlike the perpetual system where stock taking is done to verify ending inventory, under the periodic system physical stock take is done at the end of an accounting period to value ending inventory and compute COGS. Freight-in or carriage in is debited to a specific account and used in the calculation of COGS. 1

2 Perpetual is the more popular of the two as most systems are automated POS systems e.g. supermarkets, hardware stores, department stores. A periodic physical inventory is required even if other methods of inventory control are used. Sometimes merchandise can be damaged or spoiled without anyone knowing. Also, there may be shortages due to shoplifting and pilferage. These and other discrepancies will only be revealed by making an actual count of merchandise. Methods of Inventory/Stock Valuation i) Specific Identification used when each unit can be specifically identified. In this case inventory items must be physically different from each other or they must have serial numbers e.g. cars, motorcycles, furniture, appliances and fine jewellery. This method is practical only in businesses where sales volume is relatively low and inventory unit value relatively high i.e. low volume, expensive merchandise. ii) First-in, First-out (FIFO) Goods received first are the first to be issued or sold i.e. old stock is sold first. Stock is rotated forward i.e. the older units are pulled to the front of the shelves; hence the last goods remain in inventory. This method is used by businesses dealing with goods that are of a perishable nature or items that could easily become obsolete. Example iii) groceries, fresh fruits, computer software businesses. Last in, First-out (LIFO) Last stock purchased is the first to be issued or sold. Used by businesses not dealing with items that are not of a perishable nature or not likely to become obsolete e.g. nails, tiles etc. The oldest units remain in inventory. This method is not allowable since 2003 with the revision of IAS 2. iv) Average Cost (AVCO) This method assumes that the goods are homogenous; hence an average rate is applied. This method smoothes out price fluctuation. NOTE With the FIFO and LIFO methods the order of purchase or receipt of inventory is of relevance. This is not so in the case of the AVCO method. Selection of a Costing Method Selection of a costing method is dependent on the objectives of management. The reasons for a company's management adopting an inventory costing method are varied: Income Statement Effect Balance Sheet Effect Tax Effect Income Statement Effect FIFO yields the highest GP and hence the highest NP. This could result in persons viewing the company in a more favourable light. If management bonuses are based on profits, FIFO yields the highest bonuses and would be the preferred method by management. LIFO prevents the company from reporting "inflated" or "phantom" profits, as it results in the highest COS figure and hence the lowest NP. Balance Sheet Effect In times of inflation, FIFO yields the most current inventory figure. This is because the latest and most expensive items are carried forward as closing inventory. 2

3 LIFO understates inventory, which results in the understatement of current assets, net working capital and total net assets, hence distorting the true and fair view. Tax Effect LIFO yields the lowest profits and hence the lowest taxes. Companies wishing to avoid taxes will therefore choose to use LIFO even in an inflationary period. NOTE Tax Avoidance Tax Evasion This is where legal accounting gymnastics are employed to cut back on the tax liability for an accounting period. This is where taxes are not paid at all and is illegal. LIFO is not allowable under most tax laws as it often results in stock being stated in the balance sheet at amounts that bear little relationship to recent or current cost levels. Other factors to be considered in determining the basis of valuation are: i) Going Concern Concept Stock must be valued at the lower of cost or net realizable value. If a business is not a going concern, net realizable value (NRV) may be lower than normal if the stock must be disposed of in an enforced sale. ii) Matching Concept Valuing stock at NRV instead of cost matches losses to the period in which they are incurred. iii) Prudence Concept A loss in the value of stock is provided for as soon as it is recognized, by valuing the stock at NRV. iv) Consistency Concept The policy adopted for the valuation i.e. FIFO, LIFO, AVCO etc must be applied consistently from one accounting period to the next. Store keeping is the process of receiving, storing, issuing and recording stocks. The main features: i) Storing stock so that it can be easily obtained for use ii) Verifying the receipts and issues of stock so that no items are moved without documentation and authorization. iii) Safeguarding stock from damage, theft etc. Events Affecting Inventory Valuation i) Trade Discounts Deducted from gross or list price; not shown on books. ii) Materials or units returned to stores or to suppliers Taken out of purchases at the cost at which they were originally received. Reduce ending inventory balance. iii) Materials or units returned from department to stores or from customers Taken out of COGS at price originally sent. Added to ending inventory balance. Sales revenue in the IS will also be reduced. iv) Materials or units found short Added to COGS at the rate as per the method adopted i.e. LIFO, FIFO etc. Ending inventory balance will be reduced. v) Materials or units found in excess Added to purchases column at the latest purchase/issue price. Ending inventory balance will be increased by the amount. 3

4 INVENTORY/STOCK CONTROL Inventory/Stock control is the process of regulating the levels of inventory held, in order to minimize the cost for a given level of inventory/stock availability. The main features of an efficient inventory control system are: i) Recording inventory/stock levels and monitoring them against desired levels ii) Estimating the lead-time to obtain more inventory/stock. Lead-time also referred to as procurement time, is the time in days, weeks, months etc between placing an order and receipt of supplies. iii) Estimating usage during lead-time. iv) Estimating the cost of holding an item of inventory/stock v) Estimating the cost of placing an order vi) Regular reviewing of the desired inventory/stock levels Costs associated with inventory i.e. goods for resale/raw material are: 1. Purchasing Costs Cost of goods acquired from suppliers including incoming freight or transportation costs. These costs are affected by discounts relating to purchase order size. 2. Ordering Costs Costs incurred in placing and receiving order e.g. Cost of processing (clerical and document) i.e. cost of obtaining purchase approval and unloading costs. 3. Carrying/Storage Costs Costs that arise while holding inventory of goods or raw material e.g. insurance, obsolescence, handling costs, storage space, spoilage and opportunity cost of the funds tied up in inventory. 4. Stock Out Costs Costs incurred when a company runs out of inventory/stock for which there is demand. A company may respond to stock out by expediting an order from a supplier. This will result in additional ordering costs and associated transportation costs or the company may lose sale due to stock out. 5. Quality Costs Costs that result when a product is not in accordance with customer specification damaged etc. The above named costs are very important in relation to an efficient inventory/stock control system, however ordering costs and storage costs are crucial in determining the amount of inventory that should be ordered to minimize stock administration costs. Re-order Quantity Also referred to as the economic order quantity (EOQ) or economic batch quantity (EBQ) Seeks to establish the cost equilibrium between ordering cost and storage cost. Main factors to be considered in determining this quantity are ordering cost, the demand or usage and the holding or storage cost of the product. The EOQ is the optimal or largest quantity of items that should be purchased at any one time. At this level stock administration costs, namely ordering and storage or holding costs are minimized. To minimize ordering costs buy more units resulting in less orders, but large amount of inventory i.e. increased storage cost. 4

5 Cost To minimize storage or carrying cost buy lesser units, which would result in more orders but small amount of inventory i.e. increased ordering costs. Example Assume that the annual demand for an item is 10,000 units; cost per order $8.00 and the storage cost per unit $0.50. # of orders # of units storage 10,000 5,000 2,000 1, Ordering Cost $8.00 $16.00 $40.00 $80.00 $ $ $ Storage Cost* $2,500 $1,250 $500 $250 $125 $50 $25 Note that ordering costs and storage costs move in opposite directions i.e. as the number of units decrease, ordering costs increase (more orders) but storage costs decrease (fewer units to store) and vice versa. * Calculated using average inventory. Storage Cost Minimum SA Cost Equilibrium Ordering Cost EOQ Quantity Assume Co is the cost of placing an order D is the demand or usage per period Cc is the cost of carrying one unit in stock for the period a) Total Cost of Ordering = Demand x Cost of placing an order [D/Q x Co] EOQ (Q) b) Total Storage Cost = Avg. Stock Level x Unit storage cost per period [Q/2 x Cc] At the point where total ordering cost is equal to total storage cost, administration cost are minimized. [Equilibrium point] 5

6 i.e. Q/2 x Cc = D/Q x Co Q 2 Cc = 2DCo Q 2 = 2DCo/Cc Q = 2DCo/Cc [General formula] Cc and D must be expressed on the same basis i.e. weekly, monthly, quarterly etc. Calculus could also be applied to develop the equation for calculating the EOQ, by minimizing total cost. Total cost = Total storage cost + Total ordering cost = (Q/2 x Cc) + (D/Q x Co) = ½QCc + DQ -1 Co Differentiate with respect to Q TC/ Q = ½Cc DQ -2 Co At minimum TC/ Q = 0 ½Cc = DCo/Q 2 ½CcQ 2 = DCo Cc Q 2 =2DCo Q 2 = 2DCo/Cc Q = 2DCo/Cc [General formula] Re-order Level Inventory/Stock Levels This is the level at which inventory/stock should be replenished i.e. the point at which it becomes necessary to submit purchases requisition for new supplies of inventory. It is slightly higher than the minimum stock level, so those unexpected situations such as abnormal usage or increased demand and delay in delivery or increased lead-time can be properly dealt with. The main factors to be considered in setting this level are: i) Rate of consumption or usage ii) Lead-time Re-order Level = Maximum Usage x Maximum Lead-time Minimum Stock Level Also referred to as buffer or safety stock. Lowest level to which stock should fall. Low stock levels may lead to: i) "Stock outs" which may interrupt production or result in failure to meet customers demands and hence loss of goodwill. ii) Excessive purchasing department costs resulting from large volume of small orders. iii) Loss of quantity discounts obtainable from bulk purchases Minimum stock Level = Re-order Level - (Average Usage x Average Lead-time) 6

7 Maximum Stock Level Highest amount of inventory/stock to be held at any time. High inventory/stock levels may result in: i) Capital "locked up" or "tied up" in stock as idle money, which is not earning profit. ii) High storage costs Storage of stock is costly and should be kept at a minimum consistent with efficient storage. The costs include lighting, rent maintenance of stores or warehouse, wages of staff, handling costs etc. iii) Stock may be lost through deterioration i.e. where units have limited shelf life or evaporation i.e. where material is of a volatile nature. iv) Stock may become obsolete. Maximum stock level is a management warning level. If stock surpasses the maximum level the following points should be checked: i) Have any errors been made in the re-ordering or recording of stock? ii) Has the rate of usage and or lead-time been altered since the stock control levels were calculated? It may be necessary to revise the stock control level if usage and lead-time have been altered. Management should investigate to see whether the excess stock would be used up in the normal course of the business. If not, it may be necessary to treat the stock as obsolete or slow moving and dispose of it. Max. Stock Level = Re-order Level + Re-order Qty. - (Min. Usage x Min. Lead-time) Maximum and minimum stock levels should be fixed for each item of inventory/stock and re-order levels should take account of the minimum stock level, the rate of usage and lead-time required for receipt of stock after placing the order. Excessive stock may be reduced by: i) Delaying re-ordering until the stock has been reduced to the desired level. This will gradually decrease the stock level and increase the liquidity of the business. ii) Disposal of surplus by sale especially where the stock has limited shelf life. 7

Ibrahim Sameer (MBA - Specialized in Finance, B.Com Specialized in Accounting & Marketing)

Ibrahim Sameer (MBA - Specialized in Finance, B.Com Specialized in Accounting & Marketing) Introduction What is inventory control? Inventory control includes the function of inventory ordering and purchasing,