Costing and accounting systemSession 1-2

Types of inventory

•Direct material ▫Which represent direct material in

inventory awaiting manufacture.•Work in progress

▫Goods partly worked on but not fully completed

•finished goods▫Goods fully completed but not yet sold

Inventory

•Inventory is valued at cost or net realizable value.

•Net realizable value present the expected selling price minus the cost still to be incurred to sell it.

•Cost is all the expenditure incurred in getting a product or service to its present location and condition. Expenditure which relates to production overhead.

Inventory• Inventory records should be up to date in both numbers and

value because:▫ It provide control of inventory▫ Allow the value of the inventories at any point in time to be

ascertained.

• The way in which inventory costs are charged to production can have an effect on determination of the cost of production.

• Ways to value inventory: FIFO LIFO Average cost Standard cost Market price

FIFO

•It is based on charging inventories used at the earliest purchase price.

•Using this method the remaining inventory is charged on the most recent price, which can be argued to be realistic

•It is accepted in UK taxation and international accounting.

LIFO

•It charge inventories to production at most recent cost.

•In times of inflation it can argued as being realistic but it does mean that the remaining inventory tend to be undervalued in relation to market price.

•This method is not recommended as basis of valuation.

Standard costing

•A predetermined cost is established for each item for a period and is then used for charging costs o product or service.

•It have advantage of simplicity•It differ from the actual cost and need to

be checked against to insure that the difference is revised in standard cost of next period.

Market Price

•Is used when there is price volatility un basic material cost because of market condition or due to the demand and supply.

inventory• The firms needs to measure and manage inventories

efficiently and effectively in order to generate the maximum possible financial return from inventory.

• There are three reason why to hold inventory:▫ Transaction motive

Occurs when there is a need to maintain inventory to meet production and sales trends, and it is not possible to meet these needs instantly

▫ Precautionary motive Maintain additional inventories to meet unforeseen

circumstances. Uncertain future demand▫ Speculative motive

Maintain minimum or maximum level of inventory to benefit from expected increase or decrease in future prices.

Inventory• Management should ascertain the optimum

inventory level which depends on a comparison of future cost saving from purchasing now and the increase in cost resulting from holding new inventory.

• Management minimize the amount of inventory hold because of the cost associated:▫Storage and handling cost▫Finance cost▫Theft and obsoleteness▫Opportunity cost

Economic order quantity model(EOQ)

• EOQ is used due to the fact that ordering frequent and small inventory to try to lower the inventory level or to order infrequent large inventory are associated with large cost.

• The EOQ is the order quantity that yields the lowest total costs of ordering and holding the inventory.

• In simplest form, EOQ assumes that demand is constant so that inventories will be depleted evenly over time, and replenished instantly or within a constant lead time when they are needed.

Movement of inventory

EOQ assumptions

•The demand for the product can be predicted with accuracy

•Demand is constant over the period and does not fluctuate through seasonality or other reasons

•Constant reorder lead time•No safety inventory required•No discount on bulk purchases

Economic Order Quantity

D represent the annual demand for the inventory item

C represent the cost of placing an orderH represent the cost of holding one unit

of inventory for a yearExample 1.2

Effect of discount

•Obtaining large purchase order will result in discount in price which will result in cost saving:▫Reduction on ordering cost of small

frequent quantity▫Saving in purchase price

•The cost saving must be compared with increase holding cost.

▫Calculate the EOQ

▫Calculate the saving Order saving

Discount on price▫Additional cost of handling

▫Compare the values

Example:

•the cost of raw material is $14 per unit,total annual demand 18,000 unitholding cost $8ordering cost $10if the company obtained a order of 2,000 unit a discount of 5% is given

Reorder level• Periodic inventory checks may be required to

ensure that the amount of physical inventories held consistence with the indicated amount in books.

• There should be procedure for recording inventories:▫ to prevent lack duplication and lack or coordination. ▫To determine the point at which inventory should be

reordered▫ Information about the required about lead time

• Lead time : the time between the placing of an order and the receipt of the goods.

• 1.3

Reordered level •Maximum inventory level:

▫Is the level above which the inventory of any item should not normally rise.

•Minimum inventory level:▫Is the level below which the inventory of

any item should not be allowed to fall.▫It will effect the production and cause loss

▫1.4

Reordered level• Stock out

▫ Is the opportunity cost resulting from running out of inventory.

• It is difficult to predict the demand of inventories with certainty and delivery of inventories.

• Safety inventories:▫Are the inventories that are held in excess of

the expected demand during the delivery lead time to avoid running out of inventories.

1.5

Safety inventory

Just in time inventory control (JIT)• A system in which material arrives exactly as

they are needed in production.• It requires a business to build a relationship

with the supplier to provide him with small more frequent orders and building electronic orders to reduce the ordering cost.

• EOQ is concerned with minimizing the overall cost of inventory with regard to ordering and holding cost

• JIT is concerned with minimizing inventory and ideally eliminating inventory.

Advantage and disadvantage of JIT

Demand pull approach

•Under the demand pull approach each process produced what requires in the next stage

•If there is a disturbance in the next stage the production stops of the early stage until it is resolve.

Demand pull approach

Integrated accounting system•The double bookkeeping system:

▫ is a logical integrated system of keeping financial records or accounts in financial accounting system

▫It ensure that each individual transaction as recorded in at least in two different account.

•Financial accounting system:▫ intended to inform management how much is

owed to and by various external parties and to monitor overall performance of the organization

▫consider as instrumental as well as legal

Integrated accounting system• Cost accounting system:

▫ Is set up to enable an organization to work out the cost of product or service sold, or cost of particular job, contracts, or manufacturing process.

▫ There is no legal requirement to produce this information▫ Management use cost accounting for planning controlling

and decision making.• Integrated accounting:

▫ A set of accounting records that integrate both financial and cost account using a common input of data or all account purposes.

▫ This was is much cheaper quicker and more reliable than using two separate system

Advantages of using integrated system• Accuracy • Speed• Volume• Automated documentation• Updated information• Availability of information• Management information• Presentation of information• Cost saving• Ease of use• Accountability / audit trail