Inventory refers to the assets of the company which consists of raw materials, work in progress and finished goods that are ready for the sale or will be ready for the sale. It is the goods and material company holds for the ultimate purpose, resale. It is held by the organization to support production, repairs, maintenance or for sale. It is the major part of the assets of the business because inventory turnover represents one of the primary sources of the revenue generation. Inventory can also be on consignment, which is an arrangement when a company has its goods at third-party locations with ownership interest retained until goods are sold. When the inventory is sold, the carrying cost goes to the cost of goods sold on the income statement.
Organization must take care about the inventory, because at the end of the accounting period, it is one of the major factors of deciding profit and loss for the organization.
Managing inventory and stock of the company is known as Inventory Management. It is one of the elements of Supply Chain Management and includes all aspects related to inventory for instance, controlling or overseeing ordering inventory, storage of inventory and controlling the amount of product for sale. The scope of inventory management concerns the balance between replenishment lead time, carrying costs of inventory, asset management, inventory forecasting, inventory valuation, inventory visibility, future inventory price forecasting, physical inventory, available physical space, quality management, replenishment, returns and defective goods, and demand forecasting.
This entire requirement must be balanced to meet the optimal inventory level. It would include monitoring of materials moved into the stockroom and out of stockrooms.
a) Time- It is important for the producer to have certain amount of inventory because there is generally a big time difference between giving order for the inventory and receiving it. So, organization must make sure about the time when it requires the inventory so that the production process doesn’t get stopped.
b) Seasonal Demand- Demands varies periodically, but producer’s capacity is fixed. This can lead to stock accumulation; consider for example how goods consumed only in holidays can lead to accumulation of large stocks on the anticipation of future consumption.
c) Uncertainty- There is no certainty about the demand of the consumers. Their demand might get higher at a point of time, and to take the advantage of the increase in the demand of the customer, company must have enough stock of inventory to increase the level of production.
Company must have the right amount of inventory in the organization. It is crucial and a bad decision related to it may lead to incur in high cost. Company having fewer inventories than required will decrease the supply of the product and customer’s demands will not be fulfilled so they will go somewhere else. In a survey, when the business owners were asked how they decide the reordering item of the inventory, they replied with ‘previous month information.’
To calculate the right amount of inventory, previous month information should also be accurate and reliable else it might not produce the data management wants.
Firms do not like to pay more than they should be. But lower prices aren’t good. They promise lower prices for higher amount of inventory purchased. But whether is it a good sign for the company to have larger amount of inventory to gain a small amount of discount. An inventory not only increases the cost but also increase the various costs related to inventory. More the inventory, more the carrying and storage cost.
Company can find the right amount of inventory which they should have by Economic Order Quantity. It calculates the order quantity which will be economical for you company. Formula,
EOQ = √2DK/H
D = Fixed Cost per year
K = Demand in units per year.
H = Carrying cost per unit per year.
It is one of the major questions that prevail in an organization when to order inventory. EOQ helps firms in determining the quantity of inventory that should be maintained by the company but not the time of reordering of inventory.
To calculate the reorder point, firm should know about:
Reorder point = Lead Time X Avg. daily usage + Safety Stock Safety Stock = Emergency stock kept for the uncertainty. Safety Stock = [Maximum Daily Usage X Maximum Lead time (days)] – [Average daily usage X Average lead time (days)]
Two components A & B are used as follows: Normal Usage 100 per week each Minimum Usage 80 per week each Maximum Usage 200 per week each Re-ordering quantity A- 2000 Re-ordered period A- 10 to 20 weeks For each component, calculate: Re-ordering level; (b) Minimum level; (c) Maximum level; (d) Average stock level
a) Reordering Level = 200 X 20 = 4000 units b) Minimum Level = 4000-(100 x 15) = 2500 Units c) Maximum Level = 4000 + 2000 – (80 x 10) = 5200 Units d) Average Stock Level = 5200 + 2500 / 2 = 7700/2 = 3850 Units
FIFO method refers to first in, first out, meaning that the oldest inventories items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. It is done on the assumption that the goods are used in the order they are purchased.
Let’s understand the process by an illustration.
First Step: - Make FIFO Periodic. Write the total purchases made against the total sales made.
Units Available for Sales = 400 + 250 + 200 = 850 (Purchases) Units Sold = 300 + 240 = 540 (Sales) Units in Ending Inventory = 850 - 540 = 310
Second Step:- Make a table of Cost of Goods Sold.
|110 * 67.2||7392|
|200 * 83||16600|
|310 * 77.39||23992|
Third Step: - Prepare FIFO Perpetual
First of all, write the balance that is brought down in the total column. Then there is a purchase made on April 12, so write the unit, cost and total of that purchase respectively and add in the total column with the carry forward balance. Now there is a sale on 18 April, so we need to sale 300 units. And the price charged will be 75 because in this method, we will use the inventory in order we are having, so we carried the balance of previous month so we will use that inventory first and if still balance remains, then we will go forward with the purchases made. This will happen till the entry made and the balance of the unit and total must be equal to the balance of cost of goods sold ending inventory.
It is very common technique that is used in the process of valuing the inventory. It is opposite of the FIFO method because it assumes that goods which made later to the inventory are sold first and those which are manufacturer earlier are sold last.
There is a balance of units 4000 @ $5 on April 1, 2017 and on April 5, 2017 purchases of units 1000 @ $7 is made. There is a sale of 300 units. So 300 will be deducted from the last purchase of (1000 units) not 4000 units. And in the end of the month, the balance must match to the ending inventory of the cost of goods sold.
It is a method which is used to calculate the ending inventory and cost of goods sold of a period on the basis of historical gross profit of the business. It assumes that gross profit remains stable during the period.
Cost of Beginning Inventory - $25000
Net Purchase at Cost - $480,000
Freight Cost on Purchases- $20,000
Cost of Goods Available for Sale = 5,25,000
Less: Estimated Cost of Goods Sold:
Less: Estimated Gross Profit 40% - 280,000)
Estimated cost of goods sold- 420,000
Estimated cost of inventory = 525,000 – 420,000 = 105,000