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Before We Start…
It is assumed that after going through the earlier session
you are now able to:
 Explain the methods to classify inventory
 State the reason behind holding inventory
 State the different types of inventory
 Illustrate the different costs associated with inventory
holding

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Session 4

Working Capital Management

 Topics to be covered in this session:

 Inventory Management – 2

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Valuation of Stock
 The prices of goods do not remain constant
over time which results in a serious debate on
the exact valuation of stocks to be adopted.
 Accounting principles require that any system
should be consistently followed – otherwise it
becomes difficult to assess the correct position
over time.
 Varying principles result in confusion to users
of financial data and unscrupulous owners
have used such tactics to window dress their
profits and mislead investors.

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Valuation of Stock
Stocks may be valued by any of the following
methods:

 FIFO
 LIFO
 Average Cost
 Simple Average
 Weighted Average
 Moving Average

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FIFO
 Period-end inventory reflects market value
 Production will be underchanged by value of
raw materials when prices are rising & vice-
versa.
 Higher profit in an inflationary situation is
illusory. But the additional profit does not
remain with the company, as it is required to
replace raw material stock used up in
production, at current higher prices.
 Tax incidence is higher due to higher profit
booking.
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LIFO
 Profit realistic and related to market prices
 Inventory value is distorted as it reflects older
position – may be very old. Insurance claim
problems.
 If stocks are depleting, the valuation becomes
less realistic and problems of FIFO returns.
 Distorts the financial position and ratio
analysis results are also distorted.

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LIFO
 Lower tax liability
 More elaborate and complex than FIFO and
costly to implement
 Good for internal control purpose but not
favored by various authorities

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Average Cost
 Simple Average
 Sum of all unit costs (for acquisition of
different lots at different times) is divided by
the number of purchases. It ignores the size of
the different lots and all purchase prices get
equal weight.

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Average Cost
 Weighted Average
 This method corrects the distortion of the
simple average method by considering the
number of units purchased in each lot.

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Average Cost
 Moving Average
 Average unit cost is calculated after each
acquisition by taking into account the cost of
acquisition of balance stock in hand. The
advantage is that the cost can be calculated on
an ongoing basis under this system. In
previous methods the cost could be calculated
only at the end of the year

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Inventory Management
 As we have seen, there are various costs
associated with buying and carrying an
inventory. There is also a cost to be incurred if
there is shortage in inventory
 The question arises about how much to be
ordered at a time and when

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Economic Order Quantity (EOQ)

In this we assume that the following can be
determined accurately:
 Annual Total Demand – D
 Purchase cost per unit – P
 Ordering Cost – C
 Holding or Inventory carrying cost – H
We also assume that:
 Demand is uniformly spread during the year
 All goods ordered are received and taken to
stock at one time
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Economic Order Quantity

 When demand is uniform or continuous, we
can have a periodic ordering system with each
order quantity being the same – Order
Quantity – Q
 The value of Q, which minimizes the cost of
inventory is popularly known as the
Economic Order Quantity (EOQ)

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Economic Order Quantity

 Yearly Purchase Cost = P * D
 Ordering Cost =No. of orders(D/Q) * C
 Inventory Holding Cost=H * Average level of
inventory(Q/2) = H * Q/2
 If H is expressed as a percentage of the cost P,
then inventory holding cost =(P * H * Q/2)

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Economic Order Quantity

Total Cost

Holding Cost

Ordering Cost

EOQ
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Economic Order Quantity

 The Total Cost is
= (P x D) + (D x C / Q) + (Q x H / 2)
Purchase Ordering Holding
cost cost cost
 This cost has to be minimized

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Economic Order Quantity

 Value of Q at the desired level is:
Q= 2DC / H
 Optimum no. of orders is D/Q = DH / 2C
 Optimum no. of days’ supply per order is
= 365 x Q / D = 365 2C / DH

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Limitations of EOQ Model

Limitations of the EOQ Model is due to the
following occurrence in real life:
 Quite often supplies cannot be had at a time
or cannot be taken into inventory at one go.
 Demand cannot be predicted with accuracy
and the same is never completely uniform
 The different types of costs associated with
inventory are also not precisely measurable
and predictable.

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Variations in EOQ Model – Supply Over a Period of Time

If rate of supply is 'a' unit/day and rate of

consumption is 'b' units/day, then a>b
 Maximum inventory = Q – {(Q/a) * b}
 Average holding of inventory = 0.5 * [Q –
{(Q/a)*b}] = (Q/2) *{1 – (b/a)}
 Holding Cost ={(Q * H)/2}* {1 – (b/a)}
 Ordering Cost = (D * C)/Q
 EOQ value can be obtained by solving the
equation:Ordering cost = Holding cost
 Q = √ 2DC / [H {1- (b/a)}]
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Variations In EOQ Model – Costs Not Known

Minimize holding cost with same ordering cost:

 Q = √D x √2C/H = Z x √D
 Z = √D / (D/Q)
 From past data we can calculate √ D and
(D/Q) and get a value for Z so as to arrive
at Q using the equation Q = Z x √D

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Variations In EOQ Model - Demand Difficult To Predict

In such a situation, we have to start with a

projection for at least the next few weeks as no
planning can be done without any estimation
about demand (or sales), however difficult the
same may be.

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Before We End…
It is assumed that after going through the earlier session
you are now able to:
 Illustrate the need for valuation of stock
 Explain the different methods for valuation of stock and
their utilities
 Illustrate and analyze the EOQ Model
 Explain the variations in the EOQ Model

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 THANK YOU…

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