INVENTORYINVENTORYCOSTINGCOSTING

BY:- Dr. NarendranathBY:- Dr. NarendranathSenguptaSengupta

INVENTORY SYSTEM

PERPETUALINVENTORY

SYSTEM

PERIODICINVENTORY

SYSTEM

INVENTORY SYSTEMINVENTORY SYSTEMPerpetual Inventory System:-Perpetual Inventory System:-This method is This method is widely used. It is a method of recording inventory widely used. It is a method of recording inventory balances after every receipt & issue, to facilitate balances after every receipt & issue, to facilitate regular checking and to obviate closing down for regular checking and to obviate closing down for stock taking. Thus, this system gives a complete stock taking. Thus, this system gives a complete record of inventory quantities & valuation on record of inventory quantities & valuation on continuous basis.continuous basis.Periodic Inventory System:-Periodic Inventory System:-Under this the quantity Under this the quantity & value of inventory are reviewed at a fixed time & value of inventory are reviewed at a fixed time interval, such as weekly, monthly, quarterly or the interval, such as weekly, monthly, quarterly or the like.like. However, in the actual practice usually this However, in the actual practice usually this review takes place at the end of the accounting review takes place at the end of the accounting period.period.

METHOD OF INVENTORY VALUATION

HISTORICALCOST

METHOD

LOWEROF

COST

FIFO LIFOAVERAGE

COSTMETHOD

HIFO NIFOBASE

STOCKMETHOD

SPECIFIC IDENTIFICATION

First in first out (FIFO) methodFirst in first out (FIFO) method

This method uses the most recent price paid for This method uses the most recent price paid for the goods as a basis for valuation. The basis the goods as a basis for valuation. The basis philosophy behind this approach of inventory philosophy behind this approach of inventory valuation is that the first units purchased are valuation is that the first units purchased are considered the first units issued/consumed. considered the first units issued/consumed. Thus, according to FIFO method as it is Thus, according to FIFO method as it is frequently called the physical flow of the units frequently called the physical flow of the units follow a chronological order. This method is follow a chronological order. This method is most appropriate for perishable products like most appropriate for perishable products like milk, vegetables and fruits. milk, vegetables and fruits.

Advantages & disadvantages of FIFOAdvantages & disadvantages of FIFO

Advantages of FIFO:-Advantages of FIFO:-Its application is simple.Its application is simple.

It does not allow management to manipulate income.It does not allow management to manipulate income.

Its tend to produce an ending inventory cost valuation Its tend to produce an ending inventory cost valuation which approximates the current market value.which approximates the current market value.

It provides a reasonable approximation of the actual flow It provides a reasonable approximation of the actual flow of good.of good.

Disadvantage of FIFO:-Disadvantage of FIFO:-It attracts heavier tax burden if applied under inflationary It attracts heavier tax burden if applied under inflationary

incomeincome. .

It involves complicated calculation and therefore, It involves complicated calculation and therefore, it is more sensitive to clerical errors.it is more sensitive to clerical errors.

Numerical of FIFO methodNumerical of FIFO methodFollowing information is available regarding Following information is available regarding

procurement and issue of an item for the month of procurement and issue of an item for the month of February 2006:-February 2006:-

Feb 1 Opening inventory 150 units @ Rest.10 each.Feb 1 Opening inventory 150 units @ Rest.10 each.

Feb 7 Purchased 700 units @ Rs. 12 each.Feb 7 Purchased 700 units @ Rs. 12 each.

Feb 13 Issued 400 units.Feb 13 Issued 400 units.

Feb 21 Purchased 200 units @ Rs. 14 each. Feb 21 Purchased 200 units @ Rs. 14 each.

Feb 28 Issued 300 units.Feb 28 Issued 300 units.

You are required to calculate the value of the You are required to calculate the value of the inventory according to FIFO method.inventory according to FIFO method.

Last in first out (LIFO) methodLast in first out (LIFO) methodLIFO METHOD:-LIFO METHOD:- This inventory valuation method is This inventory valuation method is

based on the assumption that the last item purchased based on the assumption that the last item purchased is the first item used or sold. Thus under this method is the first item used or sold. Thus under this method the units of the earliest purchases form the ending the units of the earliest purchases form the ending inventory which results in matching of cost of current inventory which results in matching of cost of current purchases against current sales in the profit & loss purchases against current sales in the profit & loss a/c. LIFO method is appropriate during the inflationary a/c. LIFO method is appropriate during the inflationary conditions as it shows inventory at a lower value in the conditions as it shows inventory at a lower value in the balance-sheet and results in the reduction of profits & balance-sheet and results in the reduction of profits & income-taxincome-tax. . The special feature of this method is that The special feature of this method is that basis of valuation remains unchanged despite of price basis of valuation remains unchanged despite of price changes. It also tends to stabilize income by changes. It also tends to stabilize income by minimizing the effects on profits of inventory price minimizing the effects on profits of inventory price changes.changes.

Advantages and disadvantages of Advantages and disadvantages of LIFO methodLIFO method

Advantages of LIFO:-Advantages of LIFO:-LIFO attempts to reduce distortions in the profit LIFO attempts to reduce distortions in the profit and loss a/c attributable to inflation.and loss a/c attributable to inflation.It is appropriate method of involuntary valuation It is appropriate method of involuntary valuation during inventory period.during inventory period.

Disadvantages of LIFO:-Disadvantages of LIFO:-It permits management to manipulate income.It permits management to manipulate income.It is dramatically opposed to the flow of goods.It is dramatically opposed to the flow of goods.

Numerical of LIFO methodNumerical of LIFO method

Form the information for the year May 2006 relating Form the information for the year May 2006 relating to Seema & co. Ltd., calculate the value of to Seema & co. Ltd., calculate the value of inventory on 30inventory on 30thth May as per LIFO method.:- May as per LIFO method.:-

May 1 Opening stock 300 units @ Rs. 6 each.May 1 Opening stock 300 units @ Rs. 6 each.

May 7 Purchased 300 units @ Rs. 8 each.May 7 Purchased 300 units @ Rs. 8 each.

May 13 Issued 400 units.May 13 Issued 400 units.

May 21 Purchased 300 units @ Rs. 9 each.May 21 Purchased 300 units @ Rs. 9 each.

May 26 Issued 400 units.May 26 Issued 400 units.

May 30 Issued 50 units.May 30 Issued 50 units.

ILLUSTRATIONILLUSTRATION

‘‘AT’ Ltd. furnishes the following store transactions for September, 2006 :AT’ Ltd. furnishes the following store transactions for September, 2006 :1-9-061-9-06 Opening balanceOpening balance 25 units value Rs. 162.5025 units value Rs. 162.504-9-064-9-06 Issues Req. No. 85Issues Req. No. 85 8 units8 units6-9-066-9-06 Receipts from B & Co. GRN No. 26Receipts from B & Co. GRN No. 26 50 units @ Rs. 5.75 per unit50 units @ Rs. 5.75 per unit7-9-067-9-06 Issues Req. No. 97Issues Req. No. 97 12 units12 units10-9-0610-9-06 Return to B & Co.Return to B & Co. 10 units10 units12-9-0612-9-06 Issues Req. No. 108Issues Req. No. 108 15 units15 units13-9-0613-9-06 Issues Req. No. 110Issues Req. No. 110 20 units20 units15-9-0615-9-06 Receipts from M & Co. GRN. No. 33Receipts from M & Co. GRN. No. 33 25 units @ Rs. 6.10 per unit25 units @ Rs. 6.10 per unit17-9-0617-9-06 Issues Req. No. 12Issues Req. No. 12 10 units10 units

19-9-0619-9-06 Received replacement from B & Co. Received replacement from B & Co. GRN No. 38GRN No. 38 10 units10 units

20-9-0620-9-06 Returned from department, material of Returned from department, material of M & Co. MRR No. 4M & Co. MRR No. 4 5 units5 units

22-9-0622-9-06 Transfer from Job 182 to Job 187 in the Transfer from Job 182 to Job 187 in the dept. MTR 6dept. MTR 6 5 units5 units

26-9-0626-9-06 Issues Req. No. 146Issues Req. No. 146 10 units10 units29-9-0629-9-06 Transfer from Dept. “A” to Dept. “B” MTR 10Transfer from Dept. “A” to Dept. “B” MTR 10 5 units5 units30-9-0630-9-06 Shortage in stock takingShortage in stock taking 2 units2 units

Write up the priced stores ledger on FIFO method and discuss how would you treat Write up the priced stores ledger on FIFO method and discuss how would you treat the shortage in stock taking.the shortage in stock taking.

HIGHEST IN FIRST OUT(HIFO) METHODHIGHEST IN FIRST OUT(HIFO) METHOD

The HIFO method is based on the assumption that the The HIFO method is based on the assumption that the highest priced goods are sold first of irrespective of highest priced goods are sold first of irrespective of the date of their purchase. As its name implies the the date of their purchase. As its name implies the highest in, first out method (HIFO) assigns to goods highest in, first out method (HIFO) assigns to goods sold the costs of highest priced material in store. By sold the costs of highest priced material in store. By the closing time the highest priced material is the closing time the highest priced material is exhausted &, therefore, ending inventory is valued at a exhausted &, therefore, ending inventory is valued at a lower cost than its current cost. This method of lower cost than its current cost. This method of inventory valuation is appropriate for FLACTUATING inventory valuation is appropriate for FLACTUATING MARKET as it tends to provide opportunity to MARKET as it tends to provide opportunity to management to recover the cost of heavily priced management to recover the cost of heavily priced goods from the sales made at the earliest.goods from the sales made at the earliest.

Replacement cost methodReplacement cost method

Replacement cost suggest to value the inventory Replacement cost suggest to value the inventory at the replacement cost. The replacement cost at the replacement cost. The replacement cost represents the market at which, on the date of represents the market at which, on the date of the issue of the material, the goods can be the issue of the material, the goods can be replaced by purchasing the identical goods replaced by purchasing the identical goods from the market. Thus, goods issued are valued from the market. Thus, goods issued are valued at the market price on the date of their issue. at the market price on the date of their issue. This method helps inflating profit in a period of This method helps inflating profit in a period of rising prices & deflating it in a period of rising prices & deflating it in a period of declining prices. It is an appropriate valuation declining prices. It is an appropriate valuation method where management is interested to method where management is interested to reflect current price condition in costs. reflect current price condition in costs.

HOW MUCH TO ORDER?? EOQHOW MUCH TO ORDER?? EOQECONOMIC ORDERING QUANTITY:- ECONOMIC ORDERING QUANTITY:- One of One of

the major decisions in the area of inventory the major decisions in the area of inventory management is HOW MUCH (QUANTITY) TO management is HOW MUCH (QUANTITY) TO ORDER AT ONE TIME. Number of techniques ORDER AT ONE TIME. Number of techniques have been developed in which most popular have been developed in which most popular method is EOQ which represent the size of an method is EOQ which represent the size of an order for which total cost is minimum & thereby order for which total cost is minimum & thereby maximum economy in purchasing.maximum economy in purchasing.

There are two type of EOQ:-There are two type of EOQ:-ORDERING COST.ORDERING COST.CARRYING COST.CARRYING COST.

TYPES OF EOQTYPES OF EOQTYPES

OF EOQ

ORDERING

COST

CARRYING

COST

ORDERING COSTSORDERING COSTS

It is the cost of getting an item into the firm’s It is the cost of getting an item into the firm’s inventory. At the time of placing an order for inventory. At the time of placing an order for stock replenishment, certain cost are involved stock replenishment, certain cost are involved which are known as known as ordering costs. which are known as known as ordering costs. They include costs like requisition & purchase They include costs like requisition & purchase costs, follow-up costs, inspection checking & costs, follow-up costs, inspection checking & handling costs &so on. Such costs vary with the handling costs &so on. Such costs vary with the number of orders placed and the number of number of orders placed and the number of items ordered. The more frequently the orders items ordered. The more frequently the orders are placed, & fewer quantities purchased on are placed, & fewer quantities purchased on each other, the greater will be ordering costs each other, the greater will be ordering costs and vise-verse. and vise-verse.

CARRYING COSTCARRYING COSTCarrying costs:-Carrying costs:- These are those cost which are These are those cost which are

incurred in maintaining an inventory including incurred in maintaining an inventory including storage, warehousing, insurance, & interest on storage, warehousing, insurance, & interest on capital invested in inventory. There are two ways of capital invested in inventory. There are two ways of calculating EOQ.:-calculating EOQ.:-

Mathematical approach.Mathematical approach.

Graphic approach.Graphic approach.

METHODS OF CALCULATINGEOQ

MATHEMATICALAPPROACH

GRAPHIC APPROACH

ASSUMPTIONS FOR EOQ’S ASSUMPTIONS FOR EOQ’S MODELMODEL

The forecasted usage per demand for a The forecasted usage per demand for a given period is known.given period is known.

It is even throughout the year.It is even throughout the year.

Inventory can be replenished immediately.Inventory can be replenished immediately.

The cost per order is constant.The cost per order is constant.

The cost for carrying is fixed for average The cost for carrying is fixed for average level of inventory.level of inventory.

Average level of inventory=Average level of inventory=

Q+0 = QQ+0 = Q

22 2 2

Ordering cost = UFOrdering cost = UF

Q Q

U x F = UFU x F = UF

QQ Q Q

Carrying cost = Q x P x CCarrying cost = Q x P x C

22

MATHEMATICAL APPROACHMATHEMATICAL APPROACHUnder mathematical approach, it can be Under mathematical approach, it can be

expressed as:-expressed as:-

EOQ = 2 UFEOQ = 2 UF ((IN UNITS) IN UNITS) P*CP*C

Where, U = Annual usage in units.Where, U = Annual usage in units. F = Cost of placing an order/Fixed costF = Cost of placing an order/Fixed cost P = Cost per unit/Purchasing costP = Cost per unit/Purchasing cost

C = Carrying cost as a percentage of average C = Carrying cost as a percentage of average inventory. inventory.

GRAPHIC APPROACHGRAPHIC APPROACH

cost

Order size (quantity)E.O.Q

CARRYING COST

ORDERING COST

TOTAL COST

NUMERICAL ON EOQNUMERICAL ON EOQ

FROM THE FIGURES GIVEN BELOW, FROM THE FIGURES GIVEN BELOW, CALCULATE ECONOMIC ORDER CALCULATE ECONOMIC ORDER QUANTITY.:-QUANTITY.:-TOTAL CONSUMPTION ON MATERIAL TOTAL CONSUMPTION ON MATERIAL 1800 UNITS.1800 UNITS.ORDERING COST OF Rest. 20 PER ORDERING COST OF Rest. 20 PER ORDER.ORDER.CARRYING COST 10% ON AVERAGE CARRYING COST 10% ON AVERAGE INVENTORY.INVENTORY.PRICE PER UNIT Rs. 40PRICE PER UNIT Rs. 40

NUMERICALNUMERICAL

A company requires 10000 units of a certain item A company requires 10000 units of a certain item annually. The purchase price per order is Rs. annually. The purchase price per order is Rs. 20 and the fixed cost per order is Rs. 150. The 20 and the fixed cost per order is Rs. 150. The inventory carrying cost is 25% per year. inventory carrying cost is 25% per year.

a)a) Calculate EOQ.Calculate EOQ.

b)b) Suppose the supplier offers you following Suppose the supplier offers you following discount—discount—

if you order above 1000 units you will get a 2% if you order above 1000 units you will get a 2% discount. Now what decision should be taken.discount. Now what decision should be taken.

SOLUTIONSOLUTION

a)a) EOQ = 2UFEOQ = 2UF

PCPCU=10000, F=150, P=20, C=25% or 0.25

EOQ = 2x10000x150

20 x 0.25

EOQ = 775 UNITS

Our EOQ = 775 UnitsOur EOQ = 775 Units

QQ11PP22C = 775x20x0.25 = 1937.5 oldC = 775x20x0.25 = 1937.5 old

22 2 2

QQ22PP22C = 1000x19.6x0.25 = 2450 newC = 1000x19.6x0.25 = 2450 new

22 22

Increase in carrying cost = 512.50(2450-Increase in carrying cost = 512.50(2450-1937.5)1937.5)

BENEFIT:BENEFIT:Discount = 20X2 = 0.40Discount = 20X2 = 0.40

100100 0.40 X 10000 = 4,0000.40 X 10000 = 4,000

Reduction in ordering costReduction in ordering cost UF = UF = 10000X150 = 1935.48 oldUF = UF = 10000X150 = 1935.48 old

Q EOQQ EOQ 775 775Reduction in OC = 1935.48(old)-1500(new)Reduction in OC = 1935.48(old)-1500(new)

= 435.48= 435.48Total benefit = 4435.48 (Disc + Red in OC)Total benefit = 4435.48 (Disc + Red in OC)Net benefit = 3923.48 (TBenefit – TCost)Net benefit = 3923.48 (TBenefit – TCost)

If somebody offers you 2% discount, it would be If somebody offers you 2% discount, it would be better to change EOQ. EOQ in manufacturing better to change EOQ. EOQ in manufacturing is not a ultimate final word.is not a ultimate final word.

DATES

RECEIPTS ISSUES BALANCES

UNITSRATE(Rs.)

VALUE(Rs.)

UNITSRATE(RS.)

VALUE(Rs.)

UNITSRATE(Rs.)

VALUE(Rs.)

STATEMENT OF INVENTORY