What is Inventory Management?

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.

What Are Common Components of an Inventory Management System?

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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.

Investopedia explains 'Inventory'Possessing a high amount of inventory for long periods of time is not usually good for a business because of inventory storage, obsolescence and spoilage costs. However, possessing too little inventory isn't good either, because the business runs the risk of losing out on potential sales and potential market share as well.

Inventory management forecasts and strategies, such as a just-in-time inventory system, can help minimize inventory costs because goods are created or received as inventory only when needed.

Read more: http://www.investopedia.com/terms/i/inventory.asp#ixzz1vyUVzeP6

Definition of 'Economic Order Quantity - EOQ'An inventory-related equation that determines the optimum order quantity that a company should hold in its inventory given a set cost of production, demand rate and other variables. This is done to minimize variable inventory costs. The full equation is as follows:   

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)  

Investopedia explains 'Economic Order Quantity - EOQ'The EOQ formula can be modified to determine production levels or order interval lengths, and is used by large corporations around the world, especially those with large supply chains and high variable costs per unit of production.  

Despite the equation's relative simplicity by today's standards, it is still a core algorithm in the software packages that are sold to the largest companies in the world. 

Read more: http://www.investopedia.com/terms/e/economicorderquantity.asp#ixzz1vyVHLmbV

Definition of 'First In, First Out - FIFO'An asset-management and valuation method in which the assets produced or acquired first are sold, used or disposed of first. FIFO may be used by a individual or a corporation.

Investopedia explains 'First In, First Out - FIFO'For taxation purposes, FIFO assumes that the assets that are remaining in inventory are matched to the assets that are most recently purchased or produced. Because of this assumption, there are a number of tax minimization strategies associated with using the FIFO asset-management and valuation method.

Read more: http://www.investopedia.com/terms/f/fifo.asp#ixzz1vyVnFova

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.

Investopedia explains 'Shrinkage'According to the 2009 National Retail Security Survey, employee theft is the biggest contributor to shrinkage, approximately 43%, though employees are much less likely to be caught and apprehended than are shoplifters. In addition, the dollar value of employee theft incidents tends to be higher than shoplifting incidents

Read more: http://www.investopedia.com/terms/s/shrinkage.asp#ixzz1vyWGtxBF

Definition of 'Highest In, First Out - HIFO'In accounting, an inventory distribution method in which the inventory with the highest cost of purchase is the first to be used or taken out of stock. This will impact the company's books such that for any given period of time, the inventory expense will be the highest possible.

Investopedia explains 'Highest In, First Out - HIFO'Companies would likely choose to use the HIFO inventory method if they wanted to decrease their taxable income for a period of time. Because the inventory that is recorded as used up is always the most expensive inventory the company has (regardless of when the inventory was purchased), the company will always be recording maximum cost of goods sold.

Contrast this with other inventory recognition methods such as last in, first out (LIFO), in which the most recently purchased inventory is recorded as used first, or first in, first out (FIFO), in which the oldest inventory is recorded as used first. Companies may occasionally change their inventory methods in order to smooth their financial performance.

Read more: http://www.investopedia.com/terms/h/hifo.asp#ixzz1vyWekWfB

Definition of 'Inventory Turnover'A ratio showing how many times a company's inventory is sold and replaced over a period. the 

 

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". 

Investopedia explains 'Inventory Turnover'Although the first calculation is more frequently used, COGS (cost of goods sold) may be substituted because sales are recorded at market value, while inventories are usually recorded at cost. Also, average inventory may be used instead of the ending inventory level to minimize seasonal factors.

This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying.

High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall.

Read more: http://www.investopedia.com/terms/i/inventoryturnover.asp#ixzz1vydpqrJR

Inventory Turnover Ratio

Inventory turnover is the ratio of cost of goods sold to average inventory. It is an activity / efficiency ratio and it measures how many times per

period, a business sells and replaces its inventory again.

Formula

Inventory turnover ratio is calculated using the following formula:

Inventory Turnover = 

Cost of Goods Sold

Average Inventory

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. 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).

2. 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-in-

process 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.

Perpetual vs Periodic Inventory System

Perpetual inventory system and periodic inventory systems are the two systems of keeping records of

inventory.

In perpetual inventory system, merchandise inventory and cost of goods sold are updated continuously

on each sale and purchase transaction. Some other transactions may also require an update to

inventory account for example, sale/purchase return, purchase discounts etc. Purchases are directly

debited to inventory account whereas for each sale two journal entries are made: one to 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.

Differences Between Perpetual and Periodic System

Following are the main differences between perpetual and periodic inventory systems:

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.

Perpetual Inventory System Journal Entries

Under perpetual inventory system, inventory and cost of goods sold are updated for each

sale/purchase and return transaction. We have already discussed the basic concept of perpetual

inventory system in the comparison of perpetual-periodic inventory. Here we will learn the journal

entries which are typical to a perpetual inventory system:

Following are the journal entries under perpetual inventory system assuming that sales and purchases

are recorded net of discount (to learn more, see gross vs net method  of inventory purchase recording

and discount on sales.).

Inventory Purchase:

Under perpetual inventory system, a purchase is recorded by debiting inventory account and crediting

accounts payable assuming that the purchase is on credit. The journal entry is shown below:

Inventory — —

Accounts Payable—

—

Purchase Discount:

Purchase discount will reduce the inventory directly. Thus:

Accounts Payable — —

Inventory—

—

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—

—

Periodic Inventory System Journal Entries

Periodic inventory system updates inventory balance once in a period. We discussed this concept in

the perpetual-periodic inventory comparison. Here, we will learn the typical journal entries under a

periodic inventory system.

Let us assume that all sales and purchases are on credit. Also assume that where discounts are

provided or availed on sales/purchases, they are recorded using the gross method (to learn more

about gross method, see discount on sales anddiscount on inventory purchases ).

Following are the typical journal entries under a periodic inventory system:

Inventory Purchase:

The purchase of inventory is recorded by debiting purchases account and crediting accounts payable.

Purchases — —

Accounts Payable—

—

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:

COGS = Beginning Inventory + Purchases − Ending Inventory

The closing entry required in a periodic inventory system debits:

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.

Cash Discount on Inventory Purchase

When inventory is purchased from a seller offering cash discount for early payment, the buyer has an

opportunity to make payment within a specified number of days called the discount period. If the

buyer does so, the seller allows a specified percentage of the price as a discount. Such inventory on

which cash discount is offered, can be recorded by the buyer using either of the two methods known

as:

Gross Method

Net Method

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 6,000

Accounts Payable 6,000

(b) For payment with in discount period

Accounts Payable 6,000

Cash 5,520

Purchase Discounts 480

(c) For payment after discount period

Accounts Payable 6,000

Cash 6,000

Net Method Journal Entries

(a) On the date of purchase

Purchases 5,520

Accounts Payable 5,520

(b) For payment with in discount period

Accounts Payable 5,520

Cash 5,520

(c) For payment after discount period

Accounts Payable 5,520

Purchase Discounts Lost 480

Cash 6,000

Inventory Valuation Methods Introduction

Inventory valuation methods are used to calculate the cost of goods sold and cost of ending inventory.

Following are the most widely used inventory valuation methods:

1. First-In, First-Out Method

2.[1.] Last-In, First-Out Method

3.[2.] Average Cost Method

First-In, First-Out (FIFO) Method

First-In, First-Out (FIFO) is one of the methods commonly used to calculate the value of inventoryon

hand at the end of a period and the cost of goods sold during the period. This method assumes that

inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus cost

of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending

inventory. The actual flow of inventory may not exactly match the first-in, first-out pattern.

First-In, First-Out method can be applied in both the periodic inventory system and the perpetual

inventory system. The following example illustrates the calculation of ending inventory and cost of

goods sold under FIFO method:

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 Purchase 140 units @ $15.50 per unit

14 Sale 190 units @ $19.00 per unit

27 Purchase 70 units @ $16.00 per unit

29 Sale 30 units @ $19.50 per unit

Solution

FIFO Periodic

Units Available for Sale = 60 + 140 + 70 = 270

Units Sold = 190 + 30 = 220

Units in Ending Inventory = 270 − 220 = 50

       

Cost of Goods SoldUnit

s

Unit

CostTotal

Sales From Mar 1 Inventory 60 $15.00 $900

Sales From Mar 5 Purchase 140 $15.50 $2,170

Sales From Mar 27 Purchase 20 $16.00 $320

  220   $3390

       

Ending InventoryUnit

s

Unit

CostTotal

Inventory From Mar 27 Purchase 50 $16.00 $800

FIFO Perpetual

Date Purchases Sales Balance

Units Unit Cost Total Units Unit Cost Total Units Unit Cost Total

Mar 1             60 $15.00 $900

5 140 $15.50 $2,170       60 $15.00 $900

              140 $15.50 $2,170

14       60 $15.00 $900 10 $15.50 $155

        130 $15.50 $2,015      

27 70 $16.00 $1,190       10 $15.50 $155

              70 $16.00 $1,120

29       10 $15.50 $155 50 $16.00 $800

        20 $16.00 $320      

31             50 $16.00 $800

Last-In, First-Out (LIFO) Method

Last-In, First-Out is one of the common techniques used in the valuation of inventory on hand at the

end of a period and the cost of goods sold during the period. LIFO assumes that goods which made

their way to inventory (after purchase, manufacture etc.) later are sold first and those which are

manufactured or acquired early are sold last. Thus LIFO assigns the cost of newer inventory to cost of

goods sold and cost of older inventory to ending inventory account. This method is exactly opposite

to first-in, first-out method.

Last-In, First-Out method is used differently underperiodic inventory system and perpetual inventory

system. Let us use the same example that we used in FIFO method to illustrate the use of last-in, first-

out method.

Example

Use LIFO on the following information to calculate the value of ending inventory and the cost of goods

sold of March.

Mar 1 Beginning Inventory 60 units @ $15.00

5 Purchase 140 units @ $15.50

14 Sale 190 units @ $19.00

27 Purchase 70 units @ $16.00

29 Sale 30 units @ $19.50

Solution

LIFO Periodic

Units Available for Sale = 60 + 140 + 70 = 270

Units Sold = 190 + 30 = 220

Units in Ending Inventory = 270 − 220 = 50

       

Cost of Goods SoldUnit

s

Unit

CostTotal

Sales From Mar 27 Inventory 70 $16.00 $1,120

Sales From Mar 5 Purchase 140 $15.50 $2,170

Sales From Mar 1 Purchase 10 $15.00 $150

  220   $3440

       

Ending InventoryUnit

s

Unit

CostTotal

Inventory From Mar 27 Purchase 50 $15.00 $750

LIFO Perpetual

DatePurchases Sales Balance

Units Unit Cost Total Units Unit Cost Total Units Unit Cost Total

Mar 1             60 $15.00 $900

5 140 $15.50 $2,170       60 $15.00 $900

              140 $15.50 $2,170

14       140 $15.50 $2,170 10 $15.00 $150

        50 $15.00 $750      

27 70 $16.00 $1,190       10 $15.00 $150

              70 $16.00 $1,120

29       30 $16.00 $480 10 $15.00 $150

              40 $16.00 $640

31             10 $15.00 $150

              40 $16.00 $640

Average Cost (AVCO) Method

Average cost method (AVCO) calculates the cost of ending inventory and cost of goods sold for a

period on the basis of weighted average cost per unit of inventory. Weighted average cost per unit is

calculated using the following formula:

Weighted Average

 = 

Total Cost of Inventory

Unit CostTotal Units in

Inventory

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 Beginning Inventory 60 units @ $15.00 per unit

5 Purchase 140 units @ $15.50 per unit

14 Sale 190 units @ $19.00 per unit

27 Purchase 70 units @ $16.00 per unit

29 Sale 30 units @ $19.50 per unit

Solution

AVCO Periodic

Units Available for Sale = 60 + 140 + 70 = 270

Units Sold = 190 + 30 = 220

Units in Ending Inventory = 270 − 220 = 50

       

Weighted Average Unit

Cost

Unit

s

Unit

CostTotal

Mar 1 Inventory 60 $15.00 $900

Mar 5 Purchase 140 $15.50 $2,170

27 Purchase 70 $16.00 $1,120

  270 * $15.52 $4,190

* $4,190 ÷ 270      

       

Cost of Goods Sold 220 $15.52 $3,414

Ending Inventory 50 $15.52 $776

AVCO Perpetual

DatePurchases Sales Balance

Units Unit Cost Total Units Unit Cost Total Units Unit Cost Total

Mar 1             60 $15.00 $900

5 140 $15.50 $2,170       60 $15.00 $900

              140 $15.50 $2,170

              200 $15.35 $3,070

14       190 $15.35 $2,916 10 $15.35 $154

27 70 $16.00 $1,190       10 $15.35 $154

              70 $16.00 $1,120

              80 $15.92 $1,274

29       30 $15.92 $478 50 $15.92 $796

31             50 $15.92 $796

First-in-First-Out Method (FIFO)

According to FIFO, it is assumed that items from the inventory are sold in the order in which they are

purchased or produced. This means that cost of older inventory is charged to cost of goods sold first

and the ending inventory consists of those goods which are purchased or produced later. This is the

most widely used method for inventory valuation. FIFO method is closer to actual physical flow of

goods because companies normally sell goods in order in which they are purchased or produced.

Last-in-First-Out Method (LIFO)

This method of inventory valuation is exactly opposite to first-in-first-out method. Here it is assumed

that newer inventory is sold first and older remains in inventory. When prices of goods increase, cost of

goods sold in LIFO method is relatively higher and ending inventory balance is relatively lower. This is

because the cost goods sold mostly consists of newer higher priced goods and ending inventory cost

consists of older low priced items.

Average Cost Method (AVCO)

Under average cost method, weighted average cost per unit is calculated for the entire inventory on

hand which is used to record cost of goods sold. Weighted average cost per unit is calculated as

follows:

Weighted Average Cost Per Unit= 

Total Cost of Goods in Inventory

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.

Retail Method of Inventory Estimation

Retail method is a technique used to estimate the value of ending inventory using the cost to retail

price ratio. Retail method involves the following steps:

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:

Cost to Retail Ratio = 

A + B

C + D

Where,

   A is the cost of beginning inventory;

   B is the cost of inventory purchased including incidental costs such as freight-in;

   C is the retail value of beginning inventory; and

   D is the retail value of goods purchased during the period

The formula given above implies that records of a business using the retail method must show the

beginning inventory both at cost and at retail price. Since such information is readily available to retail

merchandising businesses, retailers commonly opt to use retail method to estimate the value of

ending inventory.

Example

  Cost Retail

Beginning Inventory $36,000 $46,000

Purchases $140,000 200,000

Freight-In $8,160  

Packing Cost $5,440  

Cost of Goods Available for Sale $189,600 $246,000

Cost to Retail Ratio $189,60 =

= 

0

0.7707$246,000

  Cost Retail

Cost of Goods Available for Sale $189,600 $246,000

− Sales   $198,000

Ending Inventory $48,000

× Cost to Retail Ratio 0.7707

Ending Inventory $36,994  

Gross Profit Method

Gross profit method (also known as gross margin method) is a technique used to estimate the value of

ending inventory and cost of goods sold of a period on the basis of the historical or projectedgross

profit ratio of the business. Gross profit method assumes that gross profit ratio remains stable during

the period.

This method is an alternative to the retail methodof inventory estimation and it is usually used to

estimate the value of inventory when the retail values of beginning inventory and purchases are not

available.

A summary of steps in the gross profit method is given below:

1. Calculate the cost of goods available for sale as the sum of the cost of beginning inventory and

cost of net purchases.

2. Determine the gross profit ratio. Gross profit ratio equals gross profit divided by sales. Use

projected gross profit ratio or historical gross profit ratio whichever is more accurate and reliable.

3. Multiply sales made during the period by gross profit ratio to obtain estimated cost of goods sold.

4. Calculate the cost of ending inventory as the difference of cost of goods available for sale and

estimated cost of goods sold.

Example

Cost of Beginning Inventory   $23,000

Net Purchases at Cost   352,000

Freight Cost on Purchases   25,000

Cost of Goods Available for Sale   400,000

Less: Estimated Cost of Goods Sold:    

Sales $860,000  

Estimated Gross Profit 40%  

Estimated Cost of Goods Sold   344,000

Estimated Cost of Ending Inventory   56,000

Lower of Cost or Market (LCM) Rule

Assets are generally stated in the financial statements according to the cost principle. However, in

case of inventory, cost principle is abandoned and lower of cost or market (LCM) rule takes its place.

This rule states that inventory should be measured at the lower of:

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 = 980 − 40 = $940

Replacement Cost   = $880

Lower Limit: NRV − Normal Profit = 940 − (980 − 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.

Inventory Turnover Ratio

Inventory turnover is the ratio of cost of goods sold to average inventory. It is an activity / efficiency

ratio and it measures how many times per period, a business sells and replaces its inventory again.

Formula

Inventory turnover ratio is calculated using the following formula:

Inventory Turnover = 

Cost of Goods Sold

Average Inventory

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