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Chapter 5 Inventory – The Kingpin
Inventory – The concept • Inventory includes ‘tangible property’ held for sale in the normal course of business (merchandising) and held to be used in producing goods and services for sale (manufacturing)
Inventory -Manufacturing enterprise • A manufacturing enterprise usually maintains three types of inventories • Raw materials Inventory • Work – in – process (progress) or partially completed production Inventory • Finished goods / merchandise Inventory
Objectives of Inventory Management • To choose right source of supply • To keep the investment on inventories to the minimum. • To ensure uninterrupted supply of material • To maintain optimal inventory (neither too much, nor too little) • To minimize idle time by avoiding stock outs and shortages. • To avoid carrying cost. • To improve quality of care with lesser inventory. • To avoid obsolescence of inventory • To ensure Adequate controls over materials (un-used and used).
Systems used to account for Inventory • Perpetual Inventory System, and • Periodic Inventory System. Perpetual inventory system facilitates desired data on inventory at any moment in time Periodic Inventory System is based on physical count of inventories on hand at the end of a period
Inventory Valuation Process / Cost flow methods • Specific Identification Method; • Average Cost Method; • First-in, First-out Method; and • Last-in, First - out Method.
Specific Identification Method • This method is based on the assumption that each unit (sold, purchased or in the inventory) has its own identity. The objective of specific identification method is to match the unit cost of the specific item sold with sales revenue
Average Cost Method • This method permits each purchase price to influence the inventory valuation and the cost of merchandise sold Valuation of inventory under simple average is calculated without assigning any weights, i.e., without having any regard to quantities involved. The formula used is: ‘total of rates divided by total number of rates’. In the case of weighted average, total quantities and total costs are considered in calculating average price. The formula used is ‘Total cost of goods available for sale divided by units available for sale
First – in, First out or FIFO Method • This method follows the principle of first costs into the inventory are the first costs out of the inventory Last - in, First – out or LIFO Method LIFO works on the cost flow assumption that units costs paid very recently (latest cost) shall be made applicable
Lower of the cost or market – an alternative technique of inventory valuation on conservative principle • ‘the principle to be followed for Inventory valuation should be cost or market price whichever is lower’, so that, the conservative principle of accounting is adhered to and deferment of loss does not arise
Inventory Estimation Estimating inventory through GROSS PROFIT METHOD The formula for finding gross profit ratio is: • Gross Profit of previous year Sales of previous year
Cost of inventory • The cost of holding the stock • The cost of placing an order • The cost of shortage
Classification of inventory for better control • ABC Classification (Value based classification) • A= 80% of total value, or 20% of total items. • B =15% of total value, or 30% of total items. • C = 5%, of total value or 50% of total items • VED Classification(Vital, Essential, and Desirable ) • FSN Classification (Fast moving, Slow moving and Non-moving) . • SDE Classification (Scarce, Difficult and Easy)
Inventory Control System • Internal control systems and • to protect inventory from loss and to ensure accuracy of inventory records • Management control system • relates to the systems to be designed to determine the optimum quantity of the inventory to be purchased or manufactured and deciding on the optimum price for the same