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Effective inventory management is all about knowing what is on hand, where it is in use, and how much finished product results. Inventory management is the process of efficiently overseeing the constant flow of units into and out of an existing inventory. This process usually involves controlling the transfer in of units in order to prevent the inventory from becoming too high, or dwindling to levels that could put the operation of the company into jeopardy. Competent inventory management also seeks to control the costs associated with the inventory, both from the perspective of the total value of the goods included and the tax burden generated by the cumulative value of the inventory Balancing the various tasks of inventory management means paying attention to three key aspects of any inventory. The first aspect has to do with time. In terms of materials acquired for inclusion in the total inventory, this means understanding how long it takes for a supplier to process an order and execute a delivery. Inventory management also demands that a solid understanding of how long it will take for those materials to transfer out of the inventory be established. Knowing these two important lead times makes it possible to know when to place an order and how many units must be ordered to keep production running smoothly.
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Definition of 'Inventory'
The 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 represents one of the most important assets that most businesses possess, because the turnover of inventory represents one of the primary sources of revenue generation and subsequent earnings for the company's shareholders/owners.
where : S = Setup costs D = Demand rate P = Production cost I = Interest rate (considered an opportunity cost, so the risk-free rate can be used)
Definition of 'Shrinkage'
The loss of inventory that can be attributed to factors including employee theft, shoplifting, administrative error, vendor fraud, damage in transit or in store and cashier errors that benefit the customer. Shrinkage is the difference between recorded and actual inventory. According to the National Retail Security Survey, conducted by the University of Florida, shrinkage in the United States during 2009 represented 1.44% of retail sales. This percentage amounts to billions of dollars in lost inventory each year for U.S. retailers. Security guards, security tags and cameras are used by retailers in an effort to reduce shrinkage.
The days in the period can then be divided by the inventory turnover formula to calculate the days it takes to sell the inventory on hand or "inventory turnover days".
Formula
Inventory turnover ratio is calculated using the following formula:
Average Inventory is calculated as the sum of the inventory at the beginning and at the end of the period divided by 2. Cost of goods sold figure is obtained from the income statement and the values of beginning and ending inventory are obtained from the balance sheets at the start and at the end of the accounting period.
Analysis
Inventory turnover ratio is used to measure the inventory management efficiency of a business. In general, a higher value indicates better performance and lower value means inefficiency in controlling inventory levels. A lower inventory turnover ratio may be an indication of overstocking which may pose risk of obsolescence and increased inventory holding costs. However, a very high turnover may result in loss of sales due to inventory shortage. Inventory turnover is different for different industries. Businesses which trade in perishable goods have very higher turnover with comparison to those dealing in durables. A comparison would be fair only if made between businesses of same industry.
Examples
Example 1: During the year ended December 31, 2010 Loud Corporation sold goods costing $324,000. Its average stock of goods during the same period was $23,432. Calculate the company's inventory turnover ratio. Solution Inventory Turnover Ratio = $324,000 / $23,432 = 13.83 Example 2: Cost of goods sold of a retail business during a year were $84,270; its inventory at the beginning and at the ending of the year was $9,865 and $11,650 respectively. Calculate the inventory turnover ratio of the business from the given information. Solution Average Inventory = ( $9,865 + $11,650 ) / 2 = $10,757.5 Inventory Turnover = $84,270 / $10,757.5 = 7.83
Working Capital
Working capital is a measure of liquidity of a business. It equals current assets minus current liabilities.
Formula
Working Capital = Current Assets Current Liabilities
Current assets are assets that are expected to be realized in a year or within one operating cycle. Current liabilities are obligations that are required to be paid within a year or within one operating cycle.
Analysis
If current assets of a business at the point in time are more than its current liabilities the working capital is positive, and this tells that the company is not expected to suffer from liquidity crunch in near future. However, if current assets are less than current liabilities the working capital is negative, and this communicates that the business may not be able to pay off its current liabilities when due.
Examples
1. 2. Company A has current assets of USD 5 million and current liabilities of USD 3 million. Its working capital is USD 2 million (USD 5 million minus USD 3 million). Company B has current ratio of 1.5 and its current liabilities are USD 80 million. Since current ratio is equal to current assets minus current liabilities we can calculate current assets by multiplying current ratio with current liabilities (USD 80 million*1.5=USD 120 million). Current liabilities are USD 80 million hence working capital is USD 120 million minus USD 80 million which equals USD 40 million.
Inventory Definition
Inventories consist of raw material, work-in-process and finished goods which are held by a business in ordinary course of business, either for sale or for the purpose of using them in the process of producing goods and services.
Types of Inventory
Raw Material
Raw material is a type of inventory which acts as the basic constituent of a product. For example cotton is raw material for cloth production and plastic is raw material for production of toys. Raw material is usually held by manufacturing companies because they have to manufacture goods from raw material.
Work-In-Process
Work in process is a type of inventory that is in the process of production. This means that work-inprocess inventory is in the middle of production stage and it is partly complete. Work-in-process account is used by manufacturing companies.
Finished Goods
Finished goods is a type of inventory which comes into existence after the production process in complete. Finished goods is ready for sale inventory. In financial accounting we are usually concerned with merchandise inventory. The other types of inventories are studied in cost accounting.
Cost of Inventory
When inventory is purchased, the cost of inventory includes the purchase price, delivery costs, excise and custom duties etc. less any discount that is obtained. When inventory is manufactured, its cost includes the production cost plus any cost which is incured on making the inventory saleable for example packing cost. However if abnormal cost is incurred on delivery or handling etc. then only normal portion will be added to the cost of inventory. The rest should be expensed. The valuation of ending inventory is done using FIFO, LIFO, AVCO or specific identification methods under either periodic inventory system or under perpetual inventory system.
record sale value of inventory and other to record cost of goods sold. Purchases account is not used in perpetual inventory system. In periodic inventory system, merchandise inventory and cost of goods sold are not updated continuously. Instead purchases are recorded in Purchases account and each sale transaction is recorded via a single journal entry. Thus cost of goods sold account does not exist during the accounting period. It is determined at the end of accounting period via a closing entry.
Inventory Account and Cost of Goods Sold Account are used in both systems but they are updated continuously during the period in perpetual inventory system whereas in periodic inventory system they are updated only at the end of the period.
Purchases Account and Purchase Returns and Allowances Account are only used in periodic inventory system and are updated continuously. In perpetual inventory system purchases are directly debited to inventory account and purchase returns are directly credited to inventory account.
Sale Transaction is recorded via two journal entries in perpetual system. One of them records the sale value of inventory whereas the other records cost of goods sold. In periodic inventory system, only one entry is made.
Closing Entries are only required in periodic inventory system to update inventory and cost of goods sold. Periodic inventory system does not require closing entries for inventory account.
Purchase Return: When inventory purchased is subsequently returned to the supplier, the journal entry is to debit accounts payable or accounts receivable and credit inventory account. Accounts Receivable/Accounts Payable Inventory Inventory Sale: A transaction of sale is recorded via two journal entries in perpetual inventory system. The first one records the sale value of inventory and the second one records the cost of goods sold and reduces the inventory balance. The two journal entries are shown below: Accounts Receivable Sales Cost of Goods Sold Inventory Sales Return: The recording of sales return also requires two journal entries. Which are shown below: Sales Returns Accounts Receivable/Accounts Payable Inventory Cost of Goods Sold
Purchase Discount: Under gross method, purchase discount is recorded using the following journal entry: Accounts Payable Purchase Discounts
Note: The above two journal entries are usually combined in a single entry which is shown below: Purchases Accounts Payable Purchase Discounts Purchase Return: Purchase returns are recorded as shown below Accounts Payable/Accounts Receivable Purchase Returns Inventory Sale: Unlike perpetual inventory system, the periodic inventory system records the transaction of sale via a single journal entry: Accounts Receivable Sales Sales Discounts: A sales discount is recorded as shown below: Sales Discount Accounts Receivable
Again, the above two entries are combined in a period inventory system as shown below: Accounts Receivable Sales Discounts Sales Sales Return: Similarly, sale returns are also recorded via a single journal entry: Sales Returns Accounts Receivable/Accounts Payable
At the end of each accounting period, the value of ending inventory is determined by physical count. Cost of goods sold is determined either as a balancing figure in the closing entry shown at the end or by using the following formula:
inventory account by the value of ending inventory cost of goods sold account by the value as determined above or by the balancing figure and credits:
inventory account by beginning inventory purchases account The entry is shown below: Inventory (Ending Inventory) Cost of Goods Sold (Balancing Figure) Inventory (Beginning Inventory) Purchases
A simplified form of the above journal entry uses a single debit or credit to inventory account by calculating the difference of ending inventory and beginning inventory. If the difference is positive, the inventory account will be debited for the difference and if it the difference is negative, the journal entry will credit the inventory account by the difference.
Gross Method
The gross method initially records the purchase at gross price. After that, it depends on whether the payment is made within the discount period or after. If the payment is made within the discount period, the buyer will record the payment by debiting accounts payable for the gross price, crediting
cash for the difference of gross price and discount received and crediting purchase discounts for the discount received. If discount opportunity is missed, the journal entry is made for the full payment as usual.
Net Method
The net method initially records the purchase at net price (i.e. gross price less the potential discount). If the discount is availed, the journal entry is to debit accounts payable for the net price and credit cash. If the buyer fails to make payment within the discount period, the journal entry is to debit accounts payable for the net price, debit purchase discounts lost for the discount which could be availed and crediting cash for the gross price. It is interesting to note that the purchase discounts lost represents an expense. The following example provides the journal entries to record inventory purchase using gross method and net method under periodic inventory system.
Example
Company A purchased goods having gross price of $6,000. The supplier offered discount of 8% for payments within 15 days after sale. Pass journal entries to record the purchase using gross method and net method on the following occasions: (a) At the date of purchase (b) On payment within discount period and (c) On payment after discount period Solution: Gross Method Journal Entries (a) On the date of purchase Purchases Accounts Payable (b) For payment with in discount period Accounts Payable Cash Purchase Discounts (c) For payment after discount period Accounts Payable Cash Net Method Journal Entries (a) On the date of purchase Purchases 5,520 6,000 6,000 6,000 5,520 480 6,000 6,000
Accounts Payable (b) For payment with in discount period Accounts Payable Cash (c) For payment after discount period Accounts Payable Purchase Discounts Lost Cash 5,520 480 5,520
5,520
5,520
6,000
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 60 units @ $15.00 per unit
5 14 27 29 Solution
140 units @ $15.50 per unit 190 units @ $19.00 per unit 70 units @ $16.00 per unit 30 units @ $19.50 per unit
FIFO Periodic
Units Available for Sale Units Sold Units in Ending Inventory = 60 + 140 + 70 = 190 + 30 = 270 220 = 270 = 220 = 50
Cost of Goods Sold Sales From Mar 1 Inventory Sales From Mar 5 Purchase Sales From Mar 27 Purchase
Units 50
Total $800
FIFO Perpetual
Purchases Date Units Mar 1 5 140 $15.50 $2,170 Unit Cost Total Units Unit Cost Total Units 60 60 140 Unit Cost $15.00 $15.00 $15.50 Total $900 $900 $2,170 Sales Balance
14
60 130
$15.00 $15.50
$900 $2,015
10
$15.50
$155
27
70
$16.00
$1,190
10 70
29
10 20
$15.50 $16.00
$155 $320
50
31
50
$16.00
$800
Example
Use LIFO on the following information to calculate the value of ending inventory and the cost of goods sold of March. Mar 1 5 14 27 29 Solution Beginning Inventory Purchase Sale Purchase Sale 60 units @ $15.00 140 units @ $15.50 190 units @ $19.00 70 units @ $16.00 30 units @ $19.50
LIFO Periodic
Units Available for Sale Units Sold Units in Ending Inventory = 60 + 140 + 70 = 190 + 30 = 270 220 = 270 = 220 = 50
Cost of Goods Sold Sales From Mar 27 Inventory Sales From Mar 5 Purchase Sales From Mar 1 Purchase
Units 50
Total $750
LIFO Perpetual
Purchases Date Units Mar 1 5 140 $15.50 $2,170 Unit Cost Total Units Unit Cost Total Units 60 60 140 14 140 50 27 70 $16.00 $1,190 $15.50 $15.00 $2,170 $750 10 70 29 30 $16.00 $480 10 $15.00 $16.00 $15.00 $150 $1,120 $150 10 Unit Cost $15.00 $15.00 $15.50 $15.00 Total $900 $900 $2,170 $150 Sales Balance
40 31 10 40
Like FIFO and LIFO methods, AVCO is also applied differently in periodic inventory system and perpetual inventory system. In periodic inventory system, weighted average cost per unit is calculated for the entire class of inventory. It is then multiplied with number of units sold and number of units in ending inventory to arrive at cost of goods sold and value of ending inventory respectively. In perpetual inventory system, we have to calculate the weighted average cost per unit before each sale transaction. The calculation of inventory value under average cost method is explained with the help of the following example:
Example
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 5 14 27 29 Solution Beginning Inventory Purchase Sale Purchase Sale 60 units @ $15.00 per unit 140 units @ $15.50 per unit 190 units @ $19.00 per unit 70 units @ $16.00 per unit 30 units @ $19.50 per unit
AVCO Periodic
Units Available for Sale Units Sold Units in Ending Inventory = 60 + 140 + 70 = 190 + 30 = 270 220 = 270 = 220 = 50
* $4,190 270
220 50
$15.52 $15.52
$3,414 $776
AVCO Perpetual
Purchases Date Units Mar 1 5 140 $15.50 $2,170 Unit Cost Total Units Unit Cost Total Units 60 60 140 200 14 27 70 $16.00 $1,190 190 $15.35 $2,916 10 10 70 Unit Cost $15.00 $15.00 $15.50 $15.35 $15.35 $15.35 $16.00 Total $900 $900 $2,170 $3,070 $154 $154 $1,120 Sales Balance
80 29 31 30 $15.92 $478 50 50
Total Cost of Goods in Inventory Weighted Average Cost Per Unit= Total Units in Inventory
The weighted average cost as calculated above is multiplied by number of units sold to get cost of goods sold and with number of units in ending inventory to obtain cost of ending inventory.
1. Determine the retail value of goods available for sale during the period by adding the retail value of beginning inventory and retail value of goods purchased. 2. Subtract total sales during the period from the retail value of goods available for sale. 3. Calculate the cost to retail price ratio (formula given below). 4. Multiply the difference obtained in 2nd step and the cost to retail ratio to obtain estimated cost of ending inventory. Cost to retail ratio is calculated using the following formula:
Example
Cost Beginning Inventory Purchases Freight-In Packing Cost Cost of Goods Available for Sale $36,000 $140,000 $8,160 $5,440 $189,600 $246,000 Retail $46,000 200,000
= 0.7707
$48,000 0.7707
Example
Cost of Beginning Inventory Net Purchases at Cost Freight Cost on Purchases Cost of Goods Available for Sale Less: Estimated Cost of Goods Sold: Sales Estimated Gross Profit Estimated Cost of Goods Sold Estimated Cost of Ending Inventory $860,000 40% 344,000 56,000 $23,000 352,000 25,000 400,000
Cost; or Market Value Market value means the replacement cost of theinventory. Replacement cost may be in the form of purchase cost or manufacturing cost. In other words, market value is amount that we would have to pay to acquire inventory of the same quantity and quality through purchase or through manufacture. However, upper and lower limits have been placed on the market value of inventory.
Upper limit (also called ceiling) is the net realizable value (NRV) of inventory. NRV equals expected selling price less the sum of expected cost of completion and expected cost needed to make the sale. Lower limit (also called floor) is net realizable value less normal profit margin on the inventory. The LCM rule can be applied to inventory on individual items basis, inventory class basis or to entire inventory. However the choice must be consistent.
Example
Company A owns an item of inventory having original cost of $900. Its replacement cost is $880. The company expects to sell it at $980. However an expense of $40 must be incurred to make the sale. Calculate the value of inventory according to lower of cost of market rule. Solution Upper Limit: NRV Replacement Cost Lower Limit: NRV Normal Profit = 940 (980 880) = 980 40 = $940 = $880 = $840
Since the replacement cost of $880 lies within the limits set by LCM rule, it is allowable market value of the inventory. This market value is to be compared to the original cost of inventory which is $900. Since the market value of inventory is lower than its original cost therefore it should be stated at $880 in the financial statements.
Formula
Inventory turnover ratio is calculated using the following formula:
Analysis
Inventory turnover ratio is used to measure the inventory management efficiency of a business. In general, a higher value indicates better performance and lower value means inefficiency in controlling inventory levels. A lower inventory turnover ratio may be an indication of overstocking which may pose risk of obsolescence and increased inventory holding costs. However, a very high turnover may result in loss of sales due to inventory shortage. Inventory turnover is different for different industries. Businesses which trade in perishable goods have very higher turnover with comparison to those dealing in durables. A comparison would be fair only if made between businesses of same industry.
Examples
Example 1: During the year ended December 31, 2010 Loud Corporation sold goods costing $324,000. Its average stock of goods during the same period was $23,432. Calculate the company's inventory turnover ratio. Solution Inventory Turnover Ratio = $324,000 / $23,432 = 13.83 Example 2: Cost of goods sold of a retail business during a year were $84,270; its inventory at the beginning and at the ending of the year was $9,865 and $11,650 respectively. Calculate the inventory turnover ratio of the business from the given information. Solution Average Inventory = ( $9,865 + $11,650 ) / 2 = $10,757.5 Inventory Turnover = $84,270 / $10,757.5 = 7.83