Accounting for Managerial Decision making

Accounting for Inventories

Inventories
 What are Inventories

Inventories are assets/ material/ goods:

 held for sale in ordinary course of business;

 in the process of production / processing for such sale;

 in the form of material/ supplies to be used in production/

processing or for providing services.
 Types of Inventories

Inventories

Raw Material Work in Progress Finished goods Stores & Consumables

Importance-Valuation of Inventory

Matching Concept - matching appropriate cost with

revenues- Proper determination of income

Inappropriate valuation of closing stock

Incorrect working of current year profit

Incorrect reporting of inventory in Balance-sheet

Incorrect working of profit for next year

 Cost of Goods Sold

COGS = Op Stock + Purchases – Cl Stock

 Inventory Recording Systems
Periodic Accounting System

•Recording of inventory purchase or sale in "Purchases" a/c and “Sales”- not

in inventory account.

•“Inventory a/c is updated on a periodic basis, at the end of each accounting

period (e.g., monthly, quarterly)
      .

Perpetual Accounting System

• Inventoryaccount is updated after each purchase or sale- not in “purchases”
or “purchase return”;

•COGS a/c is maintained.

 Example- Recording Systems
Transaction Periodic System Perpetual System
Purchased 200 bags for Dr Purchases 20,000 Dr Stock 20,000
Rs 100 each from Cr Hifashions 20,000 Cr Hifashions 20,000
Hifashions
Sold 120 bags to Dr Hidesign 18,000 Dr Hidesign 18,000
Hidesign for Rs 150 Cr Sales 18,000 Cr Sales 18,000
each.
Dr COGS 12,000
Cr Stock 12,000

Closing Entries Dr Sales 18,000 Dr Sales 18,000

Dr Closing Stock 8,000 Cr P&L A/c 18,000
Cr P&L A/c 26,000

Dr P&L A/c 20,000 Dr P&L A/c 12,000

Cr Purchases 20,000 Cr COGS 12,000
 Taking Physical Inventory

• Units in hands are counting at the end of an

accounting period to determine the closing
stock.

• Every enterprise need to devise a standard

procedure to take inventory.
 Valuation of Inventories

AS-2 on “Valuation of Inventory”

Lower of

Cost Net Realisable Value “NRV”

Cost of Purchase Estimated selling price

less the estimated cost
Cost of Conversion
of completion less the
Other Costs selling expenses.
 Constituents of Cost

Cost of Purchase Cost of Conversion Other Costs

Invoice price Manufacturing cost Interest cost*

+ duties & taxes + Labour cost
+ freight inward
+ Direct Overheads
+ other direct
expenses + Indirect Overheads
- Discounts/ rebates/
other such items.

* Only in cases where the value of inventory increases by ageing like wine etc
 Determination of Cost

Physical/ Actual flow Cost Flow

No assumption of order; Assumption about order in which

units have been shown.
Valuation on the basis of actual/
physical flow of inventory Methods:
Method: Specific identification • FIFO
• LIFO
 Specific Identification Method

• Specific cost is assigned to each unit sold and in hand;

• Suitable for high value, low-volume items;
• Costly to implement and may not give better results in case of
homogeneous inventory
Example:
Closing Stock contains

20 units of Purchase 1 @ Rs 200 4,000

50 units of Purchase 2 @ Rs 250 12,500
10 units of Purchase 3 @ Rs 265 2,650

Value of closing Inventory 19,150

 First in-First out (FIFO)

• Assumes that units acquired first are sold first;

• Little departure from matching concept;
• Produces highest profit in case of rising input prices and lowest
profits in case of falling input prices.
• Example-
The opening stock 200 units @ Rs 10 2,000
Purchases1 : 500 units @ Rs 15 7,500
Purchase 2 : 200 units @ Rs 20 4,000

Value of closing inventory 300 units 5,500

( 200 units @ Rs 20 and 100 units @ Rs 15)
 Last in-First out (LIFO)

• Assumes that units acquired last are sold first;

• Ensures proper matching;
• Produces lowest profit in case of rising input prices and highest
profits in case of falling input prices.
• B/S value of inventory may be outdated/unrealistic.
• Not permitted by AS-2
• Example-
The opening stock 200 units @ Rs 10 2,000
Purchases1 : 500 units @ Rs 15 7,500
Purchase 2 : 200 units @ Rs 20 4,000

Value of closing inventory 300 units 3,500

( 200 units @ Rs 20 and 100 units @ Rs 15)
 Weighted Average Cost (WAC)

• Assumes that goods available for sale are homogeneous;

• Weighted average cost is applied to closing inventory;
• Appropriate where goods are homogeneous and cost flow
assumption not possible;
• Assumes prices of all purchases; evens out the effect or price
increase/ decrease.
• Example-
The opening stock 200 units @ Rs 10 2,000
Purchases1 : 500 units @ Rs 15 7,500
Purchase 2 : 200 units @ Rs 20 4,000

Value of closing inventory 300 units 4,500

( WAC Rs 15)
 Example- Cost Flow
Opening Stock 2000 units @ Rs 150 300000

Purchases

12th April 500 units @ Rs 200 100000

6th May 1000 units @ Rs 250 250000
15th June 1000 units @ Rs 300 300000

Sales

5th April 200 units @ Rs 225 45,000

18th April 500 units @ Rs 250 125,000
9th May 1000 units @ Rs 280 280,000
20th June 800 units @ Rs 350 280,000

Closing stock 2000 units

 Example- Periodic System

FIFO LIFO WAC

Value of Closing Stock Value of Closing Stock Value of Closing Stock

1000 units @ 300 300000 2000 units @ 150 300000 WAC Rs 211 per unit
1000 units @ 250 250000 ( 950000/ 4500)

Value of Cl. Stock 550,000 Value of Cl. Stock 300,000 Value of Cl. Stock 422,222
 Example - 2
Work out COGS & value of closing Stock under Periodic & Perpetual system

Date Description Units Cost Amount

01-Apr Op. Stock 200 50 10000

05-Apr Purchase 400 55 22000

09-Apr Sale 300 65 19500

10-Apr Sale 50 65 3250

19-Apr Purchase 100 60 6000

20-Apr Sale 200 65 13000

23-Apr Sale 100 67 6700

27-Apr Purchase 200 60 12000

30-Apr Sale 100 68 6800

Closing stock 350 units

 Example- Periodic System

FIFO LIFO WAC

Value of Closing Stock Value of Closing Stock Value of Closing Stock

150 units @ 60 9000 150 units @ 50 7,500 WAC Rs 55.56/ unit

( 50,000/900)

Value of Cl. Stock 9,000 Value of Cl. Stock 7,500 Value of Cl. Stock 19,446
 Other Costing Methods
Standard Costing Method

– Cost of goods is worked out on the basis of standards of

• Material consumption & prices;
• Labour efficiency and wage rates;
• Expected level of operations etc.

– Used for cost control & management – relevant for Man A/c than Fin A/c

– AS-2 permits only if standard cost approximates to actual cost.

Base Stock Method

– Assumes minimum inventory to be held at all times;

– Base stock values at acquisition cost;

– Excess valued at other methods like FIFO, LIFO etc.

– Not permitted by AS-2.

 Lower of Cost or NRV Rule
The rule has to be applied to

– Each item of inventory; or

– Group of similar items

If applied to whole group may result in of setting the losses

with unrealised gains which is not permitted.
Example
Items Cost NRV Value
Ink Pens 5,000 4500 4500

Roller Pens 8,000 9500 8000

Ball Point Pens 6,000 5800 5800

Total 19,000 19,800 18,300

Lower of Cost or NRV if applied to group 19,000

 Estimation of Inventory
When do we need estimation of inventory??

– When taking physical inventory not possible or practical like

• Interim period;
• Inventory destroyed by flood/ fire etc;
• Estimation for insurance claim;

– For testing the reasonableness of physical inventory taken.

Methods

• Retail Inventory Method;

• Gross Profit Method
 Retail Inventory Method

• Suitable for large retail businesses like departmental store;

• The records for opening inventory and purchases have to be made both at
cost and retail price;
• Cost to retail ratio is worked out (for opening stock + Purchases);
• The ratio is applied to closing inventory to work out the cost of inventory.
Example-
Cost Retail Price
Opening Inventory 5,000 8,500
Purchases 16,000 26,500
Total for GAFS 21,000 35,000

Cost to retail ratio 60%

Less: Sales 25,000

Retail value of closing Inventory 10,000

Estimated cost of closing Inventory (@60%) 6,000

 Gross Profit Method

• Assumes that gross profit ratio remain same for different periods;
• The cost of GAFS is computed by adding cost of opening inventory and
purchases;
• Cost to goods sold is worked out by applying gross profit ratio to sales;
• Cost of closing inventory = Cost of GAFS- COGS.
Example-
Cost
Opening Inventory 5,000
Purchases 16,000
Cost of GAFS 21,000

Gross Profit ratio 25 %

Sales 25,000
COGS 20,000

Estimated cost of closing Inventory 1000

Accounting for Manufacturing Cost

• Manufacturing cost
Material cost
+ Labour cost
+ Production overheads

• Not required for financial reporting

• Done for internal purposes only.
 Example- Manufacturing Cost
Cost of goods Manufactured
Opening stock (RM) 5,000
Purchases (Net) 16,000
Fright inwards 500
21,500
Less: Closing Stock (RM) 6,500
Raw Material Cost 15,000
Labour cost 4,500
Production overheads
• Indirect Labour 750
• Power & Fuel 1,500
• Depreciation 850
• Tooling Expenses 550 3,650

Opening stock (WIP) 3,750

Less: Closing Stock (WIP) 2,620 1,130

Cost of goods Manufactured 24,280

 Example- Continued
Cost of goods Sold

Opening stock (FG) 5,000

Cost of goods manufactured 24,280
Cost GAFS 29,280
Less: Closing Stock (FG) 8,000
Cost of Goods Sold 21,280
 Production Overheads

Fixed Overheads Variable Overheads

Do not vary with volume of Vary with volume of

production production
 Costing Methods
Direct Costing
Inventories include only
variable overheads;
Fixed overheads are charged
to revenue;
Assumes that fixed
overheads not directly related
to putting inventory in present
location/ condition
Not permitted by AS-2
Absorption Costing
Inventory includes both fixed
and variable overheads
Fixed overheads are
apportioned on the basis of
• normal level of production;
• production capacity
• expected market condition
Permitted to AS-2
 Example
Opening Stock 200 units @ Rs 15 3000
Production capacity 500 units
Material & Labour cost Rs 10 per unit
Variable production o/h Rs 2 per unit
Fixed production overheads Rs 2000
Closing stock 150 units

Cost of each unit of FG Direct Costing Absorption Costing

Rs 12 per unit Rs 16 Per unit

 Inventory Management
Inventory Management

Keeping Inventory at optimum level

Excess Inventory Lower Inventory Level

Idle funds-entailing cost Danger of:

• Halt in production cycle;
• Inability to meet demand
 Financial Analysis- Inventory

Inventory Turnover Ratio : COGS/ Average Inventory

Average Inventory : (Op Stock + Cl Stock)/ 2

Average Inventory holding : 1/Inventory turnover ratio X360 days
Period

High inventory turnover : Low inventory holding period

Efficient Inventory Management

Low inventory turnover : High inventory holding period

High inventory holding cost
 Example
Cost of goods sold 48,000
Opening Inventory 3000
Closing inventory 5000
Inventory turnover ratio 12 times ( 48,000/4000)
Average inventory holding period 30 days (1/12X 365)
Questions