Inventory Management

Introduction to INVENTORY. . .
In business, any item of property held in stock by a firm,
including finished goods held for sale, goods in the process of
production, raw materials, and goods that will be consumed in the
process of producing goods to be sold. Inventories appear on a
company's balance sheet as an asset. Inventory turnover, which
indicates the rate at which goods are converted into cash, is a key
factor in appraising a firm's financial condition. Fluctuation in
the ratio of inventory to sales is known as inventory investment or
disinvestment.

The money value of the inventory also appears on the income

statement in determining the cost of the goods sold. The cost of
goods sold is determined by adding the inventory on hand at the
beginning of the period and the cost of purchasing and producing
goods during the period and subtracting from this total the
inventory on hand at the end of the period. For financial
statements inventories are usually priced (1) at cost or (2) at
cost or market value, whichever is lower. The cost of the
merchandise and materials purchased usually fluctuates during the
year, and it is necessary to determine which cost is to be used for
inventory purposes. Three methods are in general use: average cost;
first in-first out (FIFO), which assigns the cost of the last units
purchased to the inventory and the cost of the first units
purchased to the goods that were sold; and last in-first out
(LIFO), in which the reverse pattern is followed.

Definition of Inventory:
The Dictionary meaning of Inventory is 'a list of goods'. In a wider sense, inventory can be
defined as an idle resource which has an economic value. It is however, commonly used to
indicate various items of stores kept in stock in order to meet future demands. In any
organization, there may be following four types of inventory:

• (a) Raw materials & parts-- These may include all raw materials, components and assemblies
used in the manufacture of a product;
• (b) Consumables & Spares -- These may include materials required for maintenance and day-
to-day operation;
• (c) Finished Products -- Finished goods not yet sold or put into use.
• (d) Work in progress -- These are items under various stages of production not yet converted
as finished goods.

WHY DOES BUSINESS KEEP INVENTORIES?

• Meet unexpected demand
• Enjoy advantages of fluctuations in price
• Maintain and ensure regular supply to customers
• Boost liquid assets
 Purposes of Inventory Valuation

1. Determination of current income.

2. True and correct view of financial affairs.
3. Computation of ratios.

Methods of Taking Inventories.

There are two ways or methods of taking stock or inventories. These are:-

1 Periodic inventory method, and

2 Perpetual inventory method.

1.Periodic inventory

1. It is based on physical stock-taking.

2. Inventory figures are available usually once in a year.

3. Control is not possible.

4. This system is simple and does not require much cost.

5. Closing stock is determined directly by physical stock-taking.

2. Perpetual inventory

1. It is based on accounting records

2. Inventory figures are available continuously on running basis at all times.

3. It provides a basis for control. Physical stocks can be compared with book values and
discrepancies can be investigated.

4. This system is elaborate, costly and requires a lot of accounting records.

5. Cost of sales is determined directly from the accounting records.

Methods based on cost price

1. First in first out (FIFO)

2. Last in first out (LIFO)
3. Highest in first out (HIFO)
4. Specific identification price,
5. Base stock price,
6. Average price,
7. Adjusted selling price (also called retail inventory method), and
8. Latest purchase price.
 FIFO . First-in, first-out is a method of inventory accounting in which the oldest stock
items in a company's inventory are assumed to have been the first items sold. Therefore,
the inventory that remains is from the most recent purchases. In a period of rising prices,
this accounting method yields a higher ending inventory, a lower cost of goods sold, a
higher gross profit, and a higher taxable income.

The FIFO Method may come to the closest to matching the actual physical flow of
inventory. Since FIFO assumes that the oldest inventory is always sold first, the valuation
of inventory still on hand is at the most recent price. Assuming inflation, this will mean
that cost of goods sold will be at its lowest possible amount. Therefore, a major
advantage of FIFO is that it has the effect of maximizing net income within an
inflationary environment. The downside of that effect is that income taxes will be at their
greatest.

LIFO. Last-in, first-out, on the other hand, is an accounting approach that assumes that
the most recently acquired items are the first ones sold. Therefore, the inventory that
remains is always the oldest inventory. During economic periods in which prices are
rising, this inventory accounting method yields a lower ending inventory, a higher cost of
goods sold, a lower gross profit, and a lower taxable income. The LIFO Method is
preferred by many companies because it has the effect of reducing a company's taxes,
thus increasing cash flow. However, these attributes of LIFO are only present in an
inflationary environment.

The other major advantage of LIFO is that it can have an income smoothing effect.
Again, assuming inflation and a company that is doing well, one would expect inventory
levels to expand. Therefore, a company is purchasing inventory, but under LIFO, the
majority of the cost of these purchases will be on the income statement as part of cost of
goods sold. Thus, the most recent and most expensive purchases will increase cost of
goods sold, thus lowering net income before taxes, and hence net income. Net income is
still high, but it does not reach the levels that it would if the company used the FIFO
method.

Economic Order Quantity:

Depending upon various variables, different inventory models have been developed.
Different models take different costs into account. One of the popular model developed for
items of repetitive nature (dynamic), future demands for which can be projected with
certainty is Economic Order Quantity (EOQ) model.

o In addition to factors mentioned above, this model assumes that price of the material
remains constant with time and also does not vary with order quantity. This model can
be developed mathematically by differentiating total cost of inventory (ordering cost
+ inventory carrying cost) with respect to Quantity. The formula so derived is given
below :

Economic Order Quantity (EOQ) = Sq. Rt. { 2xAxCo / (Cu x Ci) }

Where, A = Annual Consumption Quantity, Co = Cost of placing one order

Ci = Annual inventory carrying cost represented as fraction,

 Cu = Unit Cost (Rate/Unit) of the material

ADVANTAGES OF KEEPING INVENTORY

• Increases capital of the Business
• Guarantees prompt service delivery
• Reinforces profitability – no stock out cost
• Enhances customer satisfaction

Disadvantages
• Carrying costs
• Associated risks
 Long-Term Assets
Long-term assets or noncurrent assets are those assets usually in service over one year such as lands
and buildings, plants and equipment, machinery, furniture & fixtures, office equipments, motor
vehicles and long-term investments. They are not held for sale in the normal course of business.
They are used by a business enterprise for the purpose of producing or providing goods or services.
These often receive favorable tax treatment over current assets. Tangible long-term assets are usually
referred to as fixed assets. All these fixed assets can be imagined as a “bundle of future services” to
be used by the enterprise over a period of years. For example, a payment made for the construction
of a building having a useful life of, say, 20 years, supply of housing service or facility. This
similarity between the cost of fixed asset and expenses prepaid is essential for understanding the
accounting process by which the cost of a fixed asset is allocated to the y ears in which benefits of
ownership are derived.

Categories of Fixed Assets.

Fixed assets are of two types:-

1. Tangible:-

(a)Unlimited Life (e.g. Land)

(b)Limited Life(e.g. Furniture)

2. Intangible:-
(a) Unlimited Term of Existence. (e.g. Trademark, Name)
(b) Limited Term of Existence. (e.g. Copyrights)

1. Tangible Assets : The term “tangible assets” is used to express those types of assets which
have bodily substance or they can be touched or seen, e.g., land, building machinery, furniture,
vehicles.
2. Intangible Assets: The term “intangible assets” is used to describe those assets which lack
physical existence. They can be feel virtually. Examples are: Patents, Copyrights, Trade Marks,
Leaseholds, Goodwill, and Organization Cost.

Characteristics of Long-term Assets

→ Have a useful life of more than one year.

→ Are acquired for use in the business.
→ Are not intended for resale to customers.
→ Must be capable of repeated use for a period of at least one year.
→ Support the operating cycle instead of being part of it.
→ Are reported at carrying (book) value.
 → Carrying value is the unexpired part of the cost of an asset.

Depreciation
Meaning
“Depreciation can be defined as permanent, continuous and gradual reduction in the book value of a
fixed asset. Normally, all the fixed assets except land, depreciate in value rendering the asset useless
after the end of certain specific period”.
Introduction
In accounting, the allocation of the cost of an asset over its
economic life. Depreciation covers deterioration from use, age, and
exposure to the elements. It also includes obsolescence—i.e., loss
of usefulness arising from the availability of newer and more
efficient types of goods serving the same purpose. It does not
cover losses from sudden and unexpected destruction resulting from
fire, accident, or disaster.
Depreciation applies both to tangible property such as machinery
and buildings and to intangibles of limited life such as leaseholds
and copyrights. It does not apply to land. For convenience,
depreciation accounts are usually kept for groups of assets with
similar characteristics and working life.

The general rule of charging off a depreciable asset during its

life does not determine what the charge will be each year.
Straight-line, fixed-percentage, and, more rarely, annuity methods
of depreciation (giving, respectively, constant, gradually
decreasing, and gradually increasing charges) are standard.
Sometimes charges vary with use (e.g., with the number of miles per
year a truck is driven). Special rules allow depletion of non
reproducible capital (such as a body of ore being mined) for tax
purposes to exceed original cost.

Basing depreciation on historical cost rather than on probable

replacement cost and on arbitrary rules rather than on actual use
has been practiced to establish definite tax liability and to
standardize audits of accounts; in times of shifting price levels,
however, such bases for measuring depreciation have proved
especially imperfect.

Definitions
According to IASC, “Depreciation is the allocation of the depreciable amount of an asset over
its estimated useful life. Depreciation for the accounting period is charged to income either directly or
indirectly”.
According to Spicer and Pegler,“The measure of exhaustion of the effective life of an asset from
any cause during a given period”.
 According to Pickles, “Depreciation is the permanent and continuing diminution in the quality, quantity
or value of an asset”.

Causes of Depreciation
1.Use Factor:- The fixed assets depreciate because they are used for the purpose they are meant
for. It is applicable in case of Tangible assets like machinery, furniture etc.

2.Time Factor:- The fixed assets depreciate due to the passage of time.

3.Obsolescence:- It is the reduction in the value of fixed assets, say a machine, due to its
supersession at a date before it completely worn out. It may take place due to new
Inventions, modifications or improvements.
.

FACTORS INFLUENCING DEPRECIATION

1. Cost of the asset:- It includes all the costs incurred for bringing the asset in usable condition. Eg:-
installation charges, hiring charge, overhauling etc.
2. Residual value or Salvage or Estimated Scrap Value:- It is the estimated net realizable value of the
asset at the end of useful life of the asset. In other words, the amount that can be fetched on the
completion of useful life of the asset is known as scrap or salvage or residual value.
3. Estimated useful life:- It depends on the total number of units produced, number of working hours, and
calendar year.
4. Estimated repairs expenditure over the life of the asset.
5. Obsolescence:- This factor should be considered while calculating the depreciation amount, because
with new invention asset becomes obsolete.

METHODS OF CHARGING DEPRECIATION

1. Straight Line Method.
2. Written Down Value/Reducing Balance Method.
3. Annuity Method.
4. Sum-Of-The-Year’s-Digits Method.
5. Depreciation Fund Method.
6. Insurance Policy Method.
7. Unit Of Production Method.
8. Machine Hour Rate Method.
9. Renewal Method
10. Revaluation Method
 1.Straight-Line Method
The amount of yearly depreciation is calculated as below.

Formula:- Cost of asset– Estimated Scrap

Estimated Life in Years

The benefit of this method is that equal amount of depreciation is charged every year throughout the life
of the asset. Drawback is that the amount of depreciation in later years is high when the utility of the
asset is reduced.

2.Reduced Balance Method

The depreciation is provided at a predetermined percentage, on the balance of cost of asset after
deducting the depreciation previously charged.
Formula: r = 1-n S
C
Where r- stands for depreciation rate;
S -for residual or salvage value less removal and disposal costs;
C- for acquisition costs including costs of installation;
And n- for estimated economic life in years.

The main benefit of this method is that it recognizes the fact that in the initial years of life of the asset,
the repairs and maintenance cost is less which goes on increasing gradually with the progressing life of
the asset.

3.Annuity Method
The annuity method considers that the business, besides losing the original cost of the asset also loses
interest, on the amount used for buying the asset, which he would have earned in case the same amount
would have been invested in some other form of investment. Thus, the asset account is debited with
interest, which is ultimately credited to Profit and Loss Account and is credited with amount of
depreciation which remains fixed year after year. The annual amount of depreciation is determined with
the help of Annuity table. The amount of total depreciation is determined by adding the cost of the asset
and interest thereon at an expected rate. The journal entries under this method are:

(A) Asset A/c Dr.

To Bank
(For purchase of asset)
(B) Asset A/c Dr.
To Interest
(For charging interest to asset)
(C) Depreciation A/c Dr.
To Asset
(For depreciation charge on asset)

4.Sum of year’s digits method

This is another method of calculating depreciation where the amount of depreciation goes on decreasing
in the coming years—the first method being written-down-value method. The rate of depreciation is
determined by the fraction where the denominator (it does not change) is the sum of the digits
representing the life of the asset and numerators (note it very carefully that it changes every year) are
individual digits used in the life of assets taken in reverse order. Thus if the life of an asset is three
years---then the denominator (which is the same for all the years) is found out by getting the sum of
digits from one to three i.e., 1+2+3 = 6; and numerator is digit picked up in the reverse order, i.e., for the
first year = 3; for the second = 2; for the third year = 1
If cost of an asset is Rs. 1,000, estimated scrap value is Rs. 100, and life of the asset is 3 years, then
depreciation charge will be determined as under:

Year Depreciation method

1 3/6 X Rs. 900* = Rs. 450

2 2/6 X Rs. 900 = Rs. 300
3 1/6 X Rs. 900 = Rs. 150

* Cost less scrap value.

Depreciation = Remaining life of the asset X Original cost

Sum of all digits of the life of the asset in years

5.Sinking Fund Method.

Unlike any other method, this method attempts to make available funds equivalent to the original
cost of asset, at the end of useful life of the asset. Depreciation to be charged is the fixed period
charge which is invested at a compound rate and the amount of investment with the compounded
interest earned over the life of the asset equal to the original cost of the asset.

6.Insurance/Endowment Policy Method

This method is similar to Depreciation Fund method, instead of securities or investment, an
insurance policy is taken. A fixed amount is paid as premium, which paid at the beginning of the
year. At the end of the specified period, agreed amount is paid by the insurance company with which
the asset can be purchased.

7.Unit-Of-Production Method or Depletion Method.

The depreciation rate under this method is determined by dividing the net acquisition or construction
cost by the estimated number of units that are likely to be produced during the useful economic life
of the asset. This rate is then applied to the number of units produced during an accounting period to
determine the depreciation to be provided during that period.

8.Machine Hour Rate Method

This method takes into account the running time of the asset for calculating depreciation. It is
usually useful for Plant & Machinery.
It is also known as Service Hours method.

9.Renewal Method
The full cost of the asset is charged as depreciation during the period in which asset is renewed. No
depreciation is charged in between the period. This method of charging can be used if the asset is of
small value and is renewed frequently.

10. Revaluation Method

In this method asset is revalued periodically. The amount of depreciation for that period is the
difference between the cost of the asset at the beginning of the period and the amount of revaluation
at the end of the period.
This method of depreciation is extensively used for the assets like livestock, patterns etc.

Submitted By:-
Sumit Jain
Roll No -53
MBA-I SEM-I