Name: Chris Mickael D.

Lacson

Year & Course: BSBA 1G

Subject: Inventory Management and Control

Accounting and Finance for Inventories

Chapter 3

Accounting for Inventories

3 Basic Types of Inventories

1. Raw Materials- are made up of goods that will be used in production of finished products.

2. Work-in-Process or WIP- consists of materials entered into the production process but not yet completed.

3. Finished Goods Inventory – includes completed products waiting to be sold.

How Inventory is Valued

In order to assign a cost value to inventory, you must make some assumptions about the inventory on hand.

There are 5 common inventory valuation methods.

1. First-in, First-out (FIFO)- this method is mostly closely tied to actual physical flow of goods in inventory.
Inventory valuation assumes that the first goods purchased are the first to be used or sold regardless of the actual
timing of their use or sale.

2. Last-in, first out (LIFO)- inventory valuation assumes that the most recently purchased/acquired goods
are the first to be used or sold regardless of actual timing of their use or sale. Since items you have just bought often
cost more than those purchased in the past, this method best matches current cost with current revenues.

3. Average cost method- it identifies the value of inventory and cost of goods sold by calculating an average
unit cost for all goods available for sale during a given period of time. This valuation method assumes that ending
inventory consists of all goods available for sale.

Average cost = Total cost of goods available for sale ÷ Total quality of goods available for sale.

4. Specific Cost Method (or actual cost method)- of inventory valuation assumes that the organization can
track the actual cost of an item unit, inventory and out of the facility. Specific costing is generally used only by
companies with sophisticated computer systems or reserved for high-value items such as artwork or customer-made
items.

5. Standard Cost Method- inventory valuation is often used by manufacturing companies to give all their
departments a uniform value for an item throughout a given year. This method is a “best guess” based on known
costs and expenses such as historical cost and any anticipated changes coming up in the foreseeable future. It is a
working tool more than a formal accounting approach.

Inventory on the Balance Sheet:

The balance sheet shows the financial position of a company on a specific date. Provides basic accounting equation
details for:

Assets = Liabilities + Equity

 Assets are the company’s resources while Liabilities and Equity are how those resources are paid for.
 Assets represent a company’s resources, form of cash or other items have monetary value (b) long term assets
such as investment and fixed assets (property/plant/equipment) or (c) intangible
assets (patents/copyrights/and goodwill.)
 Liabilities represent the amount owned to creditors (debt, accounts payable, and lease-term obligations.)
 Equity represents ownership or rights to the assets of the company (common stock, additional paid in capital,
and retained earnings.)

Know your ROI (return on investment)

ROI= REVENUE – EXPENSES INVESTMENTS

Inventory is typically counted among a company’s current assets because it can be sold within a year.

Note, however, that the balance sheet is not place that inventory plays a role in financial analysis, in fact Inventory
shows up on the income statement in the form of cost of goods sold.
 Inventory on the Income Statement

The income statement is a report that identifies a company’s revenues (sales), expenses, and resulting profits. While
a balance sheet can be described as a snapshot of a company on a specific date (June 30, for example) the income statement
covers a given period of time (June 1 through June 30). The cost of goods sold is the item on the income statement that
reflects the cost of inventory flowing out of a business.

The old saying “You make money by using or selling inventory.” Cost of goods sold (on the income statement)
represents the value of goods (inventory) sold during the accounting period.

The value of goods that are not sold is represented by the ending inventory amount on the balance sheet calculated:

Cost of goods sold = Beginning inventory + Purchases – Ending Inventory

This information is also useful because it can be used to show how a company “officially” accounts for Inventory.
With it, you can go back into the cost of purchases without knowing the actual costs by turning around the equation as
follows.

Ending Inventory = Beginning inventory + Purchases – Cost of Goods Sold

Or you can figure out of goods sold if you know what your purchases are by working the following calculation:

Purchase = Ending Inventory – Beginning inventory + Cost of Goods Sold

Ratio Analysis and What They Mean:

Ration is an expression of how many of one item is contained within another.

Ration can be used in the business world by selecting parts of an organization’s financial statements and comparing
one set of financial conditions to another.

A company’s financial statements contain key aspects of the business and by reviewing these aspects you can
determine an organization’s economic well-being. One way of reviewing these financial conditions is to compare one to
another through dividing one by the other.

Ratios are useful tools to explain trends and to summarize business results.

Third parties such as banks use ratios to determine a company’s credit worthiness.

When compared to other industries and/or company-specific figures or standards, ratios can be more powerful in
helping to analyze your company’s current and historical results.

Allow current ratio may signal or has a problem or suffering from a lack of cash flow to cover operating and other
expenses in short- and long-term obligations.

Companies in the same industry often have similar liquidity ratios or benchmarks, as they often have similar cost
structures. Your company’s ratios can be compared to:

1. Prior period (s)

2. Company goals or budget projections

3. Companies in your industry

4. Company in other industries

5. Companies in different geographic regions.

Three (3) ratios that are useful when assessing inventory.

1. Current Ratio – the current ratio assesses the organization’s overall liquidity and indicates a company’s
ability to meet its short-term obligations.

It measures whether or not a company will be able to pay its bills. The current ratio indicates how many dollars of
assets we have for each dollar of liabilities that we owe. The current ratio is calculated as follow: Current Ratio = Current
Assets ÷ Current Liabilities.
Current assets refer to assets that are in the form of cash or that are easily convertible to cash within one year, such as
accounts receivable, securities, and inventory.
Current Liabilities refers to liabilities that are due and payable within twelve months, such as accounts payable, notes payable
and short-term portion of long-term debt.

Standards for the current ratio vary from industry to industry.

What the current ratio might mean:

Allow current ratio may signal that a company has liquidity problems or has trouble meeting its short- and long-term
obligations. In other words, the organization might be suffering from a lack of cash flow to cover operating and other
expenses. As a result, accounts payable may be built at a faster rate than receivables.

A High Current Ratio is not necessarily desirable, it might indicate the company is holding high risk inventory or
maybe doing a bad job of managing its assets.

High Current Ratio result of a very large cash account, it may be an indication that the company is not reinvesting
cash appropriately.

Even though the ratio looks fine, other factors may be taken into consideration.

2. Quick Ratio or Acid Test. The quick ratio compares the organization's most liquid current assets to its
current liabilities. The quick ratio is calculated as follows:

Quick Ration= (Current Assets-Inventories) ÷Current liabilities

Assume that the industry that sells on credit has a quick ratio of at least 0.8 on the company has at least 80 cents in
liquid assets (likely in the form of accounts receivables) for every P1 of liabilities.

3. Inventory turnover ratio. The inventory turnover occurs every time an item is received, is used or sold,
and then is replaced.

Inventory turnover is an important measure since the ability to move inventory quickly directly impacts on the
company’s liquidity. Inventory turnover is calculated as follow: Inventory Turnover Ratio= Cost of Goods Sold ÷ Average
Inventory
Essentially, when a product is sold, it is subtracted from inventory and transferred to the cost of goods sold.
Therefore, this ratio indicates how quickly inventory is moving for accounting purposes.

A more accurate measure of how many times actual physical inventory turned within the site would be:

Actual physical inventory turnover ratio = Cost of Goods Sold from Inventory Only ÷ Average Inventory

Note that if inventory has increased or decreased significantly during the year, the average inventory for the year may
be skewed and not accurately reflect your turnover ratio going forward.

Also, if the company uses the LIFO method of accounting, the ratio may be inflated because LIFO may undervalue
the inventory.

Unlike the current ratio and quick ratio, the inventory turnover ratio does not adhere to the standard range.

Obsolete Stock

Any stock keeper who has had to repeatedly move really slow moving or outright dead stock out of the way or finds
herself hurting for space because obsolete product eats up square foot after square foot knows that these items “just gotta go”.

Why You Have Been Told Not to Dispose of it

Why is the dead stock still here? Three reasons most often given as to why the product can’t be disposed of are:

1. Its already paid for.

2. We might use it someday

3. We might sell it someday

These explanations seem logical and the idea of throwing away dead stock may be counterintuitive. Indeed, there are
some very real practical problems with simply hauling it off the dumpster.

Problems with Convincing the decision Makers that “It's Gotta Go”

Decision makers often have difficulty with disposing of dead inventory because it will adversely impact the balance
sheet and deplete resources considered to be valuable for lending purposes.

Impact of Write Off

Anything that appears as an asset on the balance sheet has an accounting value. This value, consisting of an item's
original cost minus depreciation, is called the “book value”. If your organization is sensitive to making extraordinary
adjustments to the balance sheet and never or seldom writes dead inventory, it may have a difficult time ever convincing any
decision maker to dispose of these items. The decision maker will simply not be willing to “take hit on the books”.

Organizations Capital Structure

Almost everyone has heard the expression “Cash is King”. It is the combination of your company’s sources of
finance. It includes equity share capital, debt, and vendor finance, to meet operational and investment requirements.

Often organizations raise operating capital by borrowing against (a) their accounts receivables and (b) the book value
of the inventory they are carrying.

Account Receivables

- Are the amounts due to customers resulting from normal sales activities.

Banker will also lend against the book of value of inventory. The more complex nature of these transactions comes
from the fact that in Accordance with Accepted Accounting practices, we should value inventory at the lower of cost are fair
market value.
Dead stock should logically be valued at a fair market value of zero dollar no matter what it originally cost.

In spite of Generally Accepted Accounting practices and even through parts of your inventory have no real market
value (and should be valued at zero dollars), banker will often loan your organization 50 to 60 percent of the value of the
inventory as the value is shown on the books.

Arguments in favor of Disposing of Dead Stock

Strong arguments can be made in favor of Disposing of non-productive stock including recapture of space, better use
of labor and equipment, plus a reduction in the costs associated with having inventory sitting around.

1. Recapture Space

In terms of space utilization, there are some simple mathematical facts to keep in mind:

· Multiplying an item's length times its width tells you the amount of square feet the item is occupying.

· Multiplying an item's length times its width times its height tells you the amount of cubic space it is
occupying.

2. Efficient utilization of labor and machine resources

Not only does obsolete inventory take up a lot of space, it can also get in the way of workers. Repeatedly moving
obsolete products out of the way hurts efficient use of both labor and machine time.

As many business writers have noted, “You cannot control what you do not measure”.

· During each week for one month, every time you or your staff move a dead product out of the
way, measure the amount of direct labor that goes to the effort.

· At the end of the month, divide the total amount of labor hours by four to determine a weekly average.

3. Reduction of carrying cost (The K factor)

The K factors represents the number of pennies per inventory dollar per year a company is spending to house its
inventory. It is generally expressed as a present.

There are two ways of computing the K factors- a traditional method in which you add together various expenses
directly related to carrying inventory and a rough rule-of-thumb method.

· Demonstrate the impact of carrying costs on your existing dead stock. This addresses the “we’ve already
paid for it”, argument in favor of retaining dead stock.

· Demonstrate that if the product remains long enough, even selling it at a profit will not recapture your
original cost. This addresses the “we might need it someday”, and “we might sell it someday”, argument in favor of
retaining dead stock.

Method of Disposal- Describes as various approaches to disposing of dead stock exist:

1. Sell a net price

2. Temporarily raise commission for sells peopl

3. Discount the price

4. Return to vendor
 5. Donate it

6. Write it off

7. Auction

It is important to remember something about convincing decision makers of anything. Ordinarily, when reports or
other information flow up a chain of command, the level of detail at each level decreases.

Carrying cost and Purchasing

Although you should only have the minimum amount of inventory on hand required for either production or
distribution. Buying small amounts frequently will lead to an excessive cost of replenishment (The R factor).

Because of the R factor, modern purchasing dictates that you buy larger quantities on fewer purchase orders, but with
suppliers releasing items on a prearranged schedule or on demand.

Ultimately, the point at which your cost or carrying inventory matches the cost of purchasing it is the proper
economic order quantity of that item.