Project Report on

Inventory Management

ANIL KUMAR Reg. No.- 521044931

A project report submitted in partial fulfillment of the requirements for the degree of MBA
in Inventory Management of Sikkim Manipal University, India.

Sikkim Manipal University of

Health, Medical & Technological
Sciences Distance Education Wing.
Syndicate House
Manipal- 576104

Session: August, 2012

Declaration

I hereby declare that the project report entitled Inventory Management

Submitted in partial fulfillment of the requirements for the degree of MBA to Sikkim
Manipal University, India, is my original work & not submitted for the award of any other
degree, diplomas, fellowship, or any other similar title or prizes.
Place: BADDI NAME: ANIL KUMAR

Date: 18/06/2012 Reg No: 521044931

Certificate

The Project Report of

ANIL KUMAR

Entitled

Inventory Management

Is approved & is acceptable in Quality & Form

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Certificate

This is to certify that the project report entitled Inventory Management

Submitted in partial fulfillment of the requirements for the degree of MBA of Sikkim Manipal
University of Health, Medical & Technological Sciences.

ANIL KUMAR

Has worked under my supervision & guidance & that no part of this report has been submitted for
the award of any other degree, diploma, fellowship or other titles or prizes & that the work has not
been published in any journal or magazine.

ANIL KUMAR

Reg. no. 521044931 Certified

INVENTORY
Inventory is a list for goods and materials, or those goods and materials
themselves, held available in stock by a business. It is also used for a list of
the contents of a household and for a list for testamentary purposes of the
possessions of someone who has died. In accounting inventory is considered
an asset. In business management, inventory consists of a list of goods and
materials held available in stock. Labels: Inventory Management,
Procurement, Supply Chain, Supply Chain Management

Contents

 1 Inventory Management
 2 Business inventory
A The reasons for keeping stock
B Special terms used in dealing with inventory
C Typology
D Inventory examples
 Manufacturing
 3 Principle of inventory proportionality
A Purpose
B Applications
C Roots
 4 High level inventory management
 5 Accounting for Inventory
A Financial accounting
B Role of Inventory Accounting
C FIFO vs. LIFO accounting
D Standard cost accounting
E Theory of Constraints cost accounting
 6 National accounts
 7 Distressed inventory
 8 Inventory credit
 9 See also
 10 References

11 Further reading
Inventory Management
Inventory management is primarily about specifying the size and placement
of stocked goods. Inventory management is required at different locations
within a facility or within multiple locations of a supply network to protect
the regular and planned course of production against the random disturbance
of running out of materials or goods. The scope of inventory management
also concerns the fine lines 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 for inventory, quality management, replenishment,
returns and defective goods and demand forecasting. Balancing these
competing requirements leads to optimal inventory levels, which is an on-
going process as the business needs shift and react to the wider environment.

Other definitions of inventory management from across the web:

Involves a retailer seeking to acquire and maintain a proper merchandise

assortment while ordering, shipping, handling, and related costs are kept in
check.

Systems and processes that identify inventory requirements, set targets,

provide replenishment techniques and report actual and projected inventory
status.

Handles all functions related to the tracking and management of material.

This would include the monitoring of material moved into and out of
stockroom locations and the reconciling of the inventory balances. Also may
include ABC analysis, lot tracking, cycle counting support etc.

Management of the inventories, with the primary objective of

determining/controlling stock levels within the physical distribution function
to balance the need for product availability against the need for minimizing
stock holding and handling costs.
 PURPOSE OF INVENTORY MANAGEMENT

 Company strategic goal.

 Sale forecasting.

 Sale and operation planning.

 Production and material requirement planning.

It provides information to efficiently manage the flow

of material effectively strategic plan. The many changes in market demand,
new
Opportunities due to Worldwide marketing global sowing of material and
new manufacturing technology mean many companies need to change their
inventory management.

It is a strategic in the since that top management goal set. These include
development strategies, control policies the determination of the optimal
level of order quantities and reorder point’s safety stock level.
.
The basis building blocks for the inventory management system and
inventory control activities are: -

 Sale forecasting or demand management.

 Sale and operation planning.

 Production planning.
 Material requirement planning.

 Inventory reduction

Objectives of inventory management

 To insure adequate stock.

 To minimize inventory on hand.
 To maintain continuity in production.
 Minimize the cost of purchasing and storage.
 To minimize the wastage and loss.
 Effective use of available capital.
 To be helpful in efficient purchasing..
 To give maximum satisfaction to customer.
 To minimize loss due to price decline.
 Maximum use of storage of capacity.
 Proper storage of material.

Basic principal of Inventory

Management
Inventory refers to a firm’s resource that can draw economic
income, including raw material, work –in-progress, finished
goods, consumable and storage inventory management involves
determining the optional level of a firm. Resources and
planning the process to achieve it. These are the following
basic principal of inventory management:-

1. Cost Minimization.
2. Forecasting
3. Supply Chain management
4. Economic order quantity.
 Inventory Management Provides:

1. Up to date information about data processing resources through

the creation.
2. Financial records specific to a single component or group
component.
3 .Component status indicators to identify a component as active.
4. Service record for all component inventory.

Success of Business through inventory management:

1. The wrong quantities of wrong item are often found on

warehouse shelves. Even through there may be lot of surplus
inventory and dead stock in their warehouse, back order and
customer losed sales are common.
2. Computer inventory records are not accurate, Inventory
balance information in the distributor expensive computer
system dose not accurately reflect what is available for sale
in the warehouse.
 Inventory Turnover ratio:

Every company is managing its inventory through maintaining some ratio

like Inventory turnover ratio, Current ratio etc .In these ratios Inventory
turnover ratio is very significant it gives direct picture of Inventory mainly
in relation to company Sales.

This calculates for getting that in how many days average inventory of
company is moving.

1. Inventory Turnover ratio:

Material consumed (3)

Average Inventory (4)

2. Inventory Turnover Holding Day:

Average Inventory
(Material consumed/365)

3. Material Consumed:

Opening Stock
Add: Purchases
Less: Closing Stock

4. Average Inventory:

Opening Inventory + Closing Inventory

 2

Business inventory
There are three basic reasons for keeping an inventory:

1. Time - The time lags present in the supply chain, from supplier to user
at every stage, requires that you maintain certain amount of inventory
to use in this "lead time".
2. Uncertainty - Inventories are maintained as buffers to meet
uncertainties in demand, supply and movements of goods.
3. Economies of scale - Ideal condition of "one unit at a time at a place
where user needs it, when he needs it" principle tends to incur lots of
costs in terms of logistics. So bulk buying, movement and storing
brings in economies of scale, thus inventory.

All these stock reasons can apply to any owner or product stage.

 Buffer stock is held in individual workstations against the possibility

that the upstream workstation may be a little delayed in long setup or
change-over time. This stock is then used while that change-over is
happening. This stock can be eliminated by tools like SMED.

These classifications apply along the whole Supply chain not just within a
facility or plant.

Where these stocks contain the same or similar items it is often the work
practice to hold all these stocks mixed together before or after the sub-
process to which they relate. This 'reduces' costs. Because they are mixed-up
together there is no visual reminder to operators of the adjacent sub-
processes or line management of the stock which is due to a particular cause
and should be a particular individual's responsibility with inevitable
consequences. Some plants have centralized stock holding across sub-
processes which makes the situation even more acute.
Special terms used in dealing with inventory

 Stock Keeping Unit (SKU) is a unique combination of all the

components that are assembled into the purchasable item. Therefore
any change in the packaging or product is a new SKU. This level of
detailed specification assists in managing inventory.
 Stock out means running out of the inventory of an SKU.
 "New old stock" (sometimes abbreviated NOS) is a term used in
business to refer to merchandise being offered for sale which was
manufactured long ago but that has never been used. Such
merchandise may not be produced any more, and the new old stock
may represent the only market source of a particular item at the
present time.

Typology

1. Buffer/safety stock
2. Cycle stock (Used in batch processes, it is the available inventory
excluding buffer stock)
3. De-coupling (Buffer stock that is held by both the supplier and the
user)
4. Anticipation stock (building up extra stock for periods of increased
demand - e.g. ice cream for summer)
5. Pipeline stock (goods still in transit or in the process of distribution -
have left the factory but not arrived at the customer yet)
Inventory examples

While accountants often discuss inventory in terms of goods for sale,

organizations - manufacturers, service-providers and not-for-profits - also
have inventories (fixtures, furniture, supplies, ...) that they do not intend to
sell. Manufacturers', distributors', and wholesalers' inventory tends to cluster
in warehouses. Retailers' inventory may exist in a warehouse or in a shop or
store accessible to customers. Inventories not intended for sale to customers
or to clients may be held in any premises an organization uses. Stock ties up
cash and if uncontrolled it will be impossible to know the actual level of
stocks and therefore impossible to control them.

While the reasons for holding stock are covered earlier, most manufacturing
organizations usually divide their "goods for sale" inventory into:

 Raw materials - materials and components scheduled for use in

making a product.
 Work in process, WIP - materials and components that have begun
their transformation to finished goods.
 Finished goods - goods ready for sale to customers.
 Goods for resale - returned goods that are salable.
Principle of inventory proportionality

Purpose
Inventory proportionality is the goal of demand driven inventory
management. The primary optimal outcome is to have the same number of
days (or hours, etc.) worth of inventory on hand across all products so that
the time of run out of all products would be simultaneous. In such a case,
there is no "excess inventory", that is, inventory that would be left over of
another product when the first product runs out. Excess inventory is sub-
optimal because the money spent to obtain it could have been deployed
better elsewhere, i.e. to the product that just ran out.

The secondary goal of inventory proportionality is inventory minimization.

By integrating accurate demand forecasting with

Inventory management, replenishment inventories can be scheduled to arrive

just in time to replenish the product destined to run out first, while at the
same time balancing out the inventory supply of all products to make their
inventories more proportional, and thereby closer to achieving the primary
goal. Accurate demand forecasting also allows the desired inventory
proportions to be dynamic by determining expected sales out into the future;
this allows for inventory to be in proportion to expected short term sales or
consumption rather than to past averages, a much more accurate and optimal
outcome.

Integrating demand forecasting with inventory management in this way also

allows for the prediction of the "can fit" point when inventory storage is
limited on a per product basis.
Applications
The technique of inventory proportionality is most appropriate for
inventories that remain unseen by the consumer. As opposed to "keep full"
systems where a retail consumer would like to see full shelves of the product
they are buying so as not to think they are buying something old, unwanted,
or stale; and differentiated from the "trigger point" systems where product is
reordered when it hits a certain level; inventory proportionality is used
effectively by just-in-time manufacturing processes and retail applications
where the product is hidden from view.

One early example of inventory proportionality used in a retail application in

the United States is for motor fuel. Motor fuel (e.g. gasoline) is generally
stored in underground storage tanks. The motorists do not know whether
they are buying gasoline off the top or bottom of the tank, nor need they
care. Additionally, these storage tanks have a maximum capacity and cannot
be overfilled. Finally, the product is expensive. Inventory proportionality is
used to balance the inventories of the different grades of motor fuel, each
stored in dedicated tanks, in proportion to the sales of each grade.
Accounting for Inventory
Each country has its own rules about accounting for inventory that fit with
their financial reporting rules.

It is intentional that financial accounting uses standards that allow the public
to compare firms' performance, cost accounting functions internally to an
organization and potentially with much greater flexibility. A discussion of
inventory from standard and Theory of Constraints-based (throughput) cost
accounting perspective follows some examples and a discussion of inventory
from a financial accounting perspective.

The internal costing/valuation of inventory can be complex. Whereas in the

past most enterprises ran simple one process factories, this is quite probably
in the minority in the 21st century. Where 'one process' factories exist then
there is a market for the goods created which establishes an independent
market value for the good. Today with multi-stage process companies there
is much inventory that would once have been finished goods which is now
held as 'work-in-process' (WIP). This needs to be valued in the accounts but
the valuation is a management decision since there is no market for the
partially finished product. This somewhat arbitrary 'valuation' of WIP
combined with the allocation of overheads to it has led to some unintended
and undesirable results.

Role of Inventory Accounting

By helping the organization to make better decisions, the accountants can
help the public sector to change in a very positive way that delivers
increased value for the taxpayer’s investment. It can also help to incentives
progress and to ensure that reforms are sustainable and effective in the long
term, by ensuring that success is appropriately recognized in both the formal
and informal reward systems of the organization.

To say that they have a key role to play is an understatement. Finance is

connected to most, if not all, of the key business processes within the
organization. It should be steering the stewardship and accountability
systems that ensure that the organization is conducting its business in an
appropriate, ethical manner. It is critical that these foundations are firmly
laid. So often they are the litmus test by which public confidence in the
institution is either won or lost.

Finance should also be providing the information, analysis and advice to

enable the organizations’ service managers to operate effectively. This goes
beyond the traditional preoccupation with budgets – how much have we
spent so far, how much have we left to spend? It is about helping the
organization to better understand its own performance. That means making
the connections and understanding the relationships between given inputs –
the resources brought to bear – and the outputs and outcomes that they
achieve. It is also about understanding and actively managing risks within
the organization and its activities.

FIFO vs. LIFO accounting

When a merchant buys goods from inventory, the value of the inventory
account is reduced by the cost of goods sold (CoG sold). This is simple
where the CoG has not varied across those held in stock; but where it has,
then an agreed method must be derived to evaluate it. For commodity items
that one cannot track individually, accountants must choose a method that
fits the nature of the sale. Two popular methods which normally exist are:
FIFO and LIFO accounting (first in - first out, last in - first out). FIFO
regards the first unit that arrived in inventory as the first one sold. LIFO
considers the last unit arriving in inventory as the first one sold. Which
method an accountant selects can have a significant effect on net income and
book value and, in turn, on taxation. Using LIFO accounting for inventory, a
company generally reports lower net income and lower book value, due to
the effects of inflation. This generally results in lower taxation. Due to
LIFO's potential to skew inventory value, UK GAAP and IAS have
effectively banned LIFO inventory accounting.
INVENTORY VALUATION

An inventory valuation allows a company to provide a monetary value for items that
make up their inventory. Inventories are usually the largest current asset of a business,
and proper measurement of them is necessary to assure accurate financial statements. If
inventory is not properly measured, expenses and revenues cannot be properly matched
and a company could make poor business decisions.

Contents
 1 Inventory and financial statements
 2 Inventory accounting systems
 3 Inventory costing methods - periodic
 4 Inventory costing methods - perpetual
 5 Periodic versus perpetual systems
 6 Using non-cost methods to value inventory
 7 Methods used to estimate inventory cost

 8 External links

Inventory and financial statements

When ending inventory is incorrect, the following balances of the balance
sheet will also be incorrect as a result: merchandise inventory, total assets,
and owner's equity.
When ending inventory is incorrect, the cost of merchandise sold and net
income will also be incorrect on the income statement.

The inventory accounting involves two major aspects:

 The cost of the purchased or manufactured inventory has to be

determined and
 Such cost is retained in the inventory accounts of the company until
the product is sold

The following methods are the most commonly used for inventory valuation
by companies:

 First-in First-Out (FIFO): the first goods to be sold (cost of sales) are
the first goods that were purchased or consumed (cost of production).
The ending inventory is formed by the last goods that were purchased
and came in at the end to the inventory.
 Last-in First-out (LIFO): the first goods to be sold (cost of sales) are
the last goods that were purchased or consumed (cost of production).
The ending inventory is formed by the first goods that were purchased
and came in at the beginning to the inventory.
 Average Cost: this method requires calculating the average unit cost
of the goods in the beginning inventory plus the purchases made in the
period. Based on this average unit cost the cost of sales (production)
and the ending inventory of the period are determined.
 Specific Identification: each article sold and each unit that remains in
the inventory is individually identified.

Inventory accounting systems

The two most widely used inventory accounting systems are the periodic
and the perpetual.

 Perpetual: The perpetual inventory system requires accounting

records to show the amount of inventory on hand at all times. It
maintains a separate account in the subsidiary ledger for each good
in stock, and the account is updated each time a quantity is added or
taken out.
 Periodic: In the periodic inventory system, sales are recorded as
they occur but the inventory is not updated. A physical inventory
must be taken at the end of the year to determine the cost of goods
 sold. Regardless of what inventory accounting system is used, it is
good practice to perform a physical inventory at least once a year.

Inventory costing methods - periodic

The periodic system records only revenue each time a sale is made. In order
to determine the cost of goods sold, a physical inventory must be taken. The
most commonly used inventory costing methods under a periodic system
are:

1. first-in first-out (FIFO),

2. last-in first-out (LIFO), and
3. Average cost or weighted average cost.

These methods produce different results because their flows of costs are
based upon different assumptions. The FIFO method bases its cost flow on
the chronological order purchases are made, while the LIFO method bases it
cost flow in a reverse chronological order. The average cost method
produces a cost flow based on a weighted average of unit costs.

Inventory costing methods - perpetual

The perpetual inventory system requires that a separate inventory ledger be
maintained for each good. Inventory ledgers provide detailed information on
purchases, cost of goods sold, and inventory on hand. Each column gives
information on quantity, unit cost, and total cost.
The most commonly used inventory costing methods under a perpetual
system are

1. first-in first-out (FIFO),

2. last-in first-out (LIFO), and
3. Average cost or weighted average cost.

In the FIFO and LIFO method, each purchase record is kept with its
purchase prices. Every piece sold is subtracted from each purchase record
until no qty is left and the next purchase record is considered. When the
average cost method is used, an average unit cost of each good is calculated
each time a purchase is made.

The advantages of the perpetual inventory system are a high degree of

control, it aids in the management of proper inventory levels, and physical
inventories can be easily compared.

Whenever a shortage (i.e. a missing or stolen good) is discovered, the

Inventory Shortages account should be debited.

Periodic versus perpetual systems

There are fundamental differences for accounting and reporting merchandise
inventory transactions under the periodic and perpetual inventory systems.

To record purchases, the periodic system debits the Purchases account while
the perpetual system debits the Merchandise Inventory account.

To record sales, the perpetual system requires an extra entry to debit the
Cost of goods sold and credit Merchandise Inventory.

By recording the cost of goods sold for each sale, the perpetual inventory
system alleviated the need for adjusting entries and calculation of the goods
sold at the end of a financial period, both of which the periodic inventory
system requires.
Using non-cost methods to value inventory
Under certain circumstances, valuation of inventory based on cost is
impractical. If the market price of a good drops below the purchase price, the
lower of cost or market method of valuation is recommended. This method
allows declines in inventory value to be offset against income of the period.
When goods are damaged or obsolete, and can only be sold for below
purchase prices, they should be recorded at net realizable value. The net
realizable value is the estimated selling price less any expense incurred to
dispose of the good.

Methods used to estimate inventory cost

In certain business operations, taking a physical inventory is impossible or
impractical. In such a situation, it is necessary to estimate the inventory cost.

Two very popular methods are 1) - retail inventory method, and 2)- gross
profit (or gross margin) method. The retail inventory method uses a cost to
retail price ratio. The physical inventory is valued at retail, and it is
multiplied by the cost ratio (or percentage) to determine the estimated cost
of the ending inventory.

The gross profit method uses the previous year’s average gross profit margin
(i.e. sales minus cost of goods sold divided by sales). Current year gross
profit is estimated by multiplying current year sales by that gross profit
margin, the current year cost of goods sold is estimated by subtracting the
gross profit from sales, and the ending inventory is estimated by adding cost
of goods sold to goods available for sale.

RAW METERIAL
A raw material is something that is acted upon or used by or by human labor
or industry, for use as a building material to create some product or
structure. Often the term is used to denote material that came from nature
and is in an unprocessed or minimally processed state. Iron ore, logs, and
crude oil, would be examples. A non-human related raw material would
include twigs and found objects as used by birds to make nests.

In Marxian economics and some industries, the term is used in a distinct

sense: raw material is a 'subject of labor', something that will be worked on
by labor that has already undergone some alteration by labor. In other words
it does not apply to materials in their entirely unprocessed state. Some
examples are dimensional lumber, glass and steel.

RAW MATERIAL

Raw materials are inventory items that are used in the manufacturer's
conversion process to produce components, subassemblies, or finished
products. These inventory items may be commodities or extracted materials
that the firm or its subsidiary has produced or extracted. They also may be
objects or elements that the firm has purchased from outside the
organization. Even if the item is partially assembled or is considered a
finished good to the supplier, the purchaser may classify it as a raw material
if his or her firm had no input into its production. Typically, raw materials
are commodities such as ore, grain, minerals, petroleum, chemicals, paper,
wood, paint, steel, and food items. However, items such as nuts and bolts,
ball bearings, key stock, casters, seats, wheels, and even engines may be
regarded as raw materials if they are purchased from outside the firm.

The bill-of-materials file in a material requirements planning system (MRP)

or a manufacturing resource planning (MRP II) system utilizes a tool known
as a product structure tree to clarify the relationship among its inventory
items and provide a basis for filling out, or "exploding," the master
production schedule. Consider an example of a rolling cart. This cart
consists of a top that is pressed from a sheet of steel, a frame formed from
four steel bars, and a leg assembly consisting of four legs, rolled from sheet
steel, each with a caster attached.

Inventory Accounting Methods: LIFO, FIFO, Weighted

Average and Specific Identification
Inventory represents goods the company plans to sell its customers.
Depending on the nature of the firm’s operations, inventories can include
raw production materials, work in process, finished goods, and/or
merchandise inventory. The balance in this account is also affected by
accounting decisions.

Accounting standards permit various acceptable inventory measurement

methods, including last-in-first-out (LIFO), first-in-first-out (FIFO),
weighted average, and specific identification. Specific identification has
been used most frequently for inventories in which the separate items are
distinct and have a high cost, such as fine jewelry, because the benefit to be
gained from tracking these individual items is high. For lower-cost items in
inventory, the value of such specific tracking is low unless a company is
using powerful digital databases that allow detailed inventory tracking to be
readily and cheaply accomplished.

Even if a company uses sophisticated technology to control inventory, the

accounting measures do not have to reflect precise physical flows, as would
occur using specific identification. Rather, the LIFO, FIFO, and weighted
average methods refer to assumptions that are made about the flow of
inventory through the company. Using FIFO, the company assumes that the
first goods sold are the oldest and the most recently acquired items remain in
inventory on the balance sheet. Using LIFO, the costs of the oldest inventory
are maintained on the balance sheet under the assumption that the most
recently acquired inventory is sold first. The weighted average method uses
average costs over the reporting period to calculate the inventory balance.
The effect of accounting choices on the income statement and balance sheet
is presented below.
INVENTORY VALUATION
Effectively measuring and managing inventory is essential in keeping
companies financial statements up to date; inventories are a part of the
balance sheet and are represented as short-term assets. Inventory can be
defined as assets that are held for the purpose of sale or inventory can refer
to assets that are being converted to a form which can be sold or even assets
that assist in the production of goods which will be sold.

To determine how much inventory a company has on hand, the following

formula can be used. It is pretty straight forward, take the inventory at hand
at the start of the reporting period and add any new inventory purchases and
then subtract the cost of any inventory that has been sold.
Inventory Valuation
Inventory valuation and management is a very important part of managing
the current assets account on the balance sheet. If this aspect is not done
properly, the ramifications are far reaching; total assets and shareholders
equity wil be affected on the balance sheet while net income will be affected
on the income statement.

In order to properly manage and match up revenues derived from the cost of
inventory, companies use the following inventory valuation methodologies;
First-In First-Out (FIFO), Last-In Last-Out (LIFO), Average Cost, and
Specific Identification.

First-in First-out (FIFO)

In this method material is first issued from the earliest consignment on hand
and priced at the cost at which that consignment was placed in the stores.
Materials received first are issued first. The units in the opening stock of
materials are treated as if they are issued first, the units from the first
purchase issue next, and so on until the units left in the closing stock of
materials are valued at the latest cost of purchases. This method is most
suitable in times of falling prices because the issue price of materials to jobs
or works orders will be high while the cost of replacement of materials will
be low.

For example, assume that a textile company created 500 tablecloths at a cost
of $1.00 per unit and then created another 1000 with a unit cost of $1.25.
The revenue from the sale of the first 500 table clothes will be matched up
with the tablecloths which have a cost basis of $1.00.

FIFO –First in first out

Sales
Production
500 @1.00 1000@1.25 500@1.15

Ist input IInd Input IIIrd Input

Used for First Used next Used for

500 sales Next 1000 Last 500sales
sales

Last –in –First Out (LIFO)

LIFO takes the opposite approach to FIFO; it matches in the reverse order.
The first sale is matched against the last product produced and therefore, the
last good sold will be matched up with the first good produced. Basically,
LIFO is assuming that a company sells off its last product produced, first.
The diagram below takes the same example from above and depicts LIFO
inventory management.

LIFO-Last- in First -out

Production

500 @1.00 1000@1.25 500@1.15

Sales
Used for Used next Used for
LAST500 sales Next 1000 FIRST
sales 500sales

Average Cost
The average cost method of inventory management is pretty straight
forward. This method values inventory costs as the average unit
cost between the assets in the beginning inventory and the newly acquired
assets. There is no inventory matching required.

Specific Identification
Specific identification is more manually intensive method of managing
inventory. Companies will literally identify each item in inventory and
record the capital gain (loss) when that specific item is sold. Each item will
remain in the inventory until it is sold.

CONCLUSION
Choosing the appropriate methodology is a difficult task as there are many
unknown variables that go into the decision, such as inflation or shelf life.
With high inflation, or in markets with prices increasing, companies will
achieve higher profits by matching sales against inventory which was
produced at lower prices; earnings per share will increase but so will tax
liability due to an increase in profits. Using LIFO on the other hand will
produce the opposite effect. In essence, you will be matching new sales
against higher production costs, thereby lowering net income and EPS.
Some companies may actually prefer this to keep their tax liability down.
Companies cannot use different methodologies when reporting to the
government and their shareholders so choosing either one may be a gift or a
curse. Also remember, when analyzing inventory valuations, it is important
to compare one company against another company in the same industry.
How Do We Value Inventory?

The accounting method that a company decides to use to determine the costs
of inventory can directly impact the balance sheet, income statement and
statement of cash flow. There are three inventory-costing methods that are
widely used by both public and private companies:
 First-In, First-Out (FIFO) - This method assumes that the first unit
making its way into inventory is the first sold. For example, let's say
that a bakery produces 200 loaves of bread on Monday at a cost of $1
each, and 200 more on Tuesday at $1.25 each. FIFO states that if the
bakery sold 200 loaves on Wednesday, the COGS is $1 per loaf
(recorded on the income statement) because that was the cost of each
of the first loaves in inventory. The $1.25 loaves would be allocated to
ending inventory (appears on the balance sheet).

 Last-In, First-Out (LIFO) - This method assumes that the last unit
making its way into inventory is sold first. The older inventory,
therefore, is left over at the end of the accounting period. For the 200
loaves sold on Wednesday, the same bakery would assign $1.25 per
loaf to COGS while the remaining $1 loaves would be used to
calculate the value of inventory at the end of the period.
  Average Cost - This method is quite straightforward; it takes
the weighted average of all units available for sale during the
accounting period and then uses that average cost to determine the
value of COGS and ending inventory. In our bakery example, the
average cost for inventory would be $1.125 per unit, calculated as
[(200 x $1) + (200 x $1.25)]/400.
An important point in the examples above is that COGS appears on the
income statement, while ending inventory appears on the balance sheet
under current assets. (For more insight, see Reading The Balance Sheet.)

Why Is Inventory Important?

If inflation were nonexistent, then all three of the inventory valuation
methods would produce the exact same results. When prices are stable our
bakery would be able to produce all of its loafs of bread at $1, and FIFO,
LIFO and average cost would give us a cost of $1 per loaf.

Unfortunately, the world is more complicated. Over the long term, prices
tend to rise, which means the choice of accounting method can dramatically
affect valuation ratios.

If prices are rising, each of the accounting methods produce the following
results:
 FIFO gives us a better indication of the value of ending inventory (on
the balance sheet), but it also increases net income because inventory
that might be several years old is used to value the cost of goods sold.
Increasing net income sounds good, but remember that it also has the
potential to increase the amount of taxes that a company must pay.


 LIFO isn't a good indicator of ending inventory value because the left
over inventory might be extremely old and, perhaps, obsolete. This
results in a valuation that is much lower than today's prices. LIFO
results in lower net income because cost of goods sold is higher.
 Average cost produces results that fall somewhere between FIFO and
LIFO.
(Note: if prices are decreasing then the complete opposite of the above is
true.)
One thing to keep in mind is that companies are prevented from getting the
best of both worlds. If a company uses LIFO valuation when it files taxes,
which results in lower taxes when prices are increasing, it then must also use
LIFO when it reports financial results to shareholders. This lowers net
income and, ultimately, earnings per share.

Example

Let's examine the inventory of Cory's Tequila Co. (CTC) to see how the different
inventory valuation methods can affect the financial analysis of a company.

Monthly Inventory Purchases*

Month Units Purchased Cost/ea Total Value
January 1,000 $10 $10,000
February 1,000 $12 $12,000
March 1,000 $15 $15,000
Total 3,000
Beginning Inventory = 1,000 units purchased at $8 each (a total of
4,000 units)

Income Statement (simplified): January-March*

Averag
Item LIFO FIFO
e
Sales = 3,000 units @ $60,00 $60,00 $60,00
$20 each 0 0 0
 Beginning Inventory 8,000 8,000 8,000
Purchases 37,000 37,000 37,000
Ending Inventory
(appears on B/S) 8,000 15,000 11,250
*See calculation below
$37,00 $30,00 $33,75
COGS
0 0 0
Expenses 10,000 10,000 10,000
$13,00 $20,00 $16,25
Net Income
0 0 0

*Note: All calculations assume that there are 1,000 units left for ending
inventory:
(4,000 units - 3,000 units sold = 1,000 units left)

What we are doing here is figuring out the ending inventory, the results of
which depend on the accounting method, in order to find out what COGS is.
All we've done is rearrange the above equation into the following:

Beginning Inventory + Net Purchases - Ending Inventory = Cost of Goods

Sold

LIFO Ending
1,000 units X $8 each = $8,000
Inventory Cost =
Remember that the last units in are sold first; therefore, we leave
the oldest units for ending inventory.

FIFO Ending
1,000 units X $15 each = $15,000
Inventory Cost =
Remember that the first units in (the oldest ones) are sold first;
therefore, we leave the newest units for ending inventory.

Average Cost Ending [(1,000 x 8) + (1,000 x 10) + (1,000 x

Inventory = 12) + (1,000 x 15)]/4000 units =
 $11.25 per unit

1,000 units X $11.25 each = $11,250

Remember that we take a weighted average of all the units in
inventory.

Using the information above, we can calculate various performance and

leverage ratios. Let's assume the following:

Assets (not including

$150,000
inventory)
Current assets (not including
$100,000
inventory)
Current liabilities $40,000
Total liabilities $50,000

Each inventory valuation method causes the various ratios to produce

significantly different results (excluding the effects of income taxes):

Average
Ratio LIFO FIFO
Cost
Debt-to-Asset 0.32 0.30 0.31
Working
2.7 2.88 2.78
Capital
Inventory
7.5 4.0 5.3
Turnover
Gross Profit 38&percnt 50&percnt
44%
Margin ; ;
CONCLUSION
l note, many companies will also state that they use the "lower of cost or
market". This means that if inventory values were to plummet, their
valuations would represent the market value (or replacement cost) instead of
FIFO, LIFO or average cost.

There are basis approaches to valuing inventory that are allowed by GAAP -
(a) First-in, First-out (FIFO): Under FIFO, the cost of goods sold is based
upon the cost of material bought earliest in the period, while the cost of
inventory is based upon the cost of material bought later in the year. This
results in inventory being valued close to current replacement cost. During
periods of inflation, the use of FIFO will result in the lowest estimate of cost
of goods sold among the three approaches, and the highest net income.

Given the income and cash flow effects of inventory valuation methods, it is
often difficult to compare firms that use different methods. There is,
however, one way of adjusting for these differences. Firms that choose to
use the LIFO approach to value inventories have to specify in a footnote the
difference in inventory valuation between FIFO and LIFO, and this
difference is termed the LIFO reserve. This can be used to adjust the
beginning and ending inventories, and consequently the cost of goods sold,
and to restate income based upon FIFO valuation.
 THIRD PARTY

The open taps inventory management system provides for third party
storage of inventory. To manage the staging of your inventory, you can
have inventory held for your at a supplier or another third party
warehousing vendor who is listed as your Supplier in Purchasing >
Suppliers Tab. Then, you can pull inventory into your primary pick/pack
warehouse to fulfill orders as you need them.

For example, you may have a supplier make a year's supplier of a part at
bulk quantities and stock them for you at their warehouse. Then, as the
stock in your warehouse is diminished, you can transfer them from the
supplier to your warehouse. Periodically, as the supplier's warehouse
stock is diminished, you may need to place another order with your
supplier.

Open taps supports third party inventory, and you can set it up in the
following way:

Set up Backup Warehouses representing the vendors who will be

holding inventory for you, with the vendor as owner of the facility (and
the inventory in it).
Set up Inventory Stock Levels for both your primary warehouse and
your backup which is the supplier's warehouse. For example, you may
have a minimum stock of 10 in your primary warehouse and 100,000 in
your supplier's warehouse.

Run Material Resources Planning (MRP) on your primary warehouse

to determine if inventory needs to be transferred from your vendor to
you. You can also run MRP on your (backup) vendor's warehouse
periodically to determine if you need to reorder.

Inventory transfers (requirements or requests depending up settings) will

be automatically created for you by MRP from your supplier's warehouse
to your primary warehouse. You can then transfer inventory by approving
transfers from your supplier's warehouse to your warehouse when needed
or as suggested by MRP.

After you transfer the inventory into your warehouse, create a "vendor
invoice" (using Financials > Payables Tab > [Create Vendor Invouce]
button > in the New Invoice Item box, "Type" = "Inventory Xfer In")
from your supplier and use the invoice item type "Inventory Xfer In".
Once this invoice is set to "Ready", it will offset the accounting payable
entries for inventory transferred in with accounts payable entries for your
supplier.

For your supplier's warehouse, MRP will create requirements for

purchasing additional stock when it is below the targeted minimum stock
there. You can then approve those requirements and create purchase
orders for your supplier.

Receive the inventory into your supplier's warehouse to track the

quantities open with your vendor.
Third party inventory.
Valuation:

FIFO:-
In this method material is first issued from the earliest consignment on hand
and priced at the cost at which that consignment was placed in the stores.
Materials received first are issued first. The units in the opening stock of
materials are treated as if they are issued first, the units from the first
purchase issue next, and so on until the units left in the closing stock of
materials are valued at the latest cost of purchases. This method is most
suitable in times of falling prices because the issue price of materials to jobs
or works orders will be high while the cost of replacement of materials will
be low.

For example, assume that a textile company created 500 tablecloths at a cost
of $1.00 per unit and then created another 1000 with a unit cost of $1.25.
The revenue from the sale of the first 500 table clothes will be matched up
with the tablecloths which have a cost basis of $1.00.
 FIFO-First in First out
Sales
Production
500 @1.00 1000@1.25 500@1.15

Ist input IInd Input IIIrd Input

Used for First Used next Used for

500 sales Next 1000 Last 500sales
sales
 CERTIFICATE

M/S ABC INDUSTRIES

PLOT NO: 216, NEAR: TRP Pvt ltd., PO: PRAGPUR, TEHSIL:
DEHRA DIST: KANGRA (H.P).01970-329488

Stock statement: Physical for financial year 2009-10

Item: AI Casting for processing

Model F.G IN-PROCESS TOTAL

A 48 104 152
B 384 181 565
C 6480 1184 7664
D 640 141 781
E 960 400 1360
F 0 200 200
TOTAL 8512 2210 10722
Note:
Following physical stock taking is done in presence of XYZ
Representatives as under signed

For ABC I

For ABC Industries For XYZ Industries

Third Party Process for valuate Stock

M/S ABC LTD

Item name X Y Z
PCS PCS PCS
Opening Stock As on Date 0 0 0

Add Issue 1000 1000 1000

Less : Received Back process 500 600 700

Less : Received Back
unprocessed 100 0 0
Balance as on Date 400 400 300
RECEIVED
QTY WT TOTAL
X 500 0 500
Y 600 0 600
Z 700 0 700
TOTAL 2000
Managing Third Party Inventory
The open taps inventory management system provides for third party storage
of inventory. To manage the staging of your inventory, you can have
inventory held for your at a supplier or another third party warehousing
vendor who is listed as your Supplier in Purchasing >

Suppliers Tab. Then, you can pull inventory into your primary pick/pack
warehouse to fulfill orders as you need them.

For example, you may have a supplier make a year's supplier of a part at
bulk quantities and stock them for you at their warehouse. Then, as the stock
in your warehouse is diminished, you can transfer them from the supplier to
your warehouse. Periodically, as the supplier's warehouse stock is
diminished, you may need to place another order with your supplier.

Open taps supports third party inventory, and you can set it up in the
following way:

1) Set up Backup Warehouses representing the vendors who will be

holding inventory for you, with the vendor as owner of the facility
(and the inventory in it).
2) Set up Inventory Stock Levels for both your primary warehouse and
your backup which is the supplier's warehouse. For example, you may
have a minimum stock of 10 in your primary warehouse and 100,000
in your supplier's warehouse.
3) Run Material Resources Planning (MRP) on your primary warehouse
to determine if inventory needs to be transferred from your vendor to
you. You can also run MRP on your (backup) vendor's warehouse
periodically to determine if you need to reorder.
4) Inventory transfers (requirements or requests depending up settings)
will be automatically created for you by MRP from your supplier's
warehouse to your primary warehouse. You can then transfer
inventory by approving transfers from your supplier's warehouse to
your warehouse when needed or as suggested by MRP.
5) After you transfer the inventory into your warehouse, create a "vendor
invoice" (using Financials > Payables Tab > [Create Vendor Invoice]
button > in the New Invoice Item box, "Type" = "Inventory Xfer In")
 from your supplier and use the invoice item type "Inventory Xfer In".
Once this invoice is set to "Ready", it will offset the accounting
payable entries for inventory transferred in with accounts payable
entries for your supplier.
6) For your supplier's warehouse, MRP will create requirements for
purchasing additional stock when it is below the targeted minimum
stock there. You can then approve those requirements and create
purchase orders for your supplier.
7) Receive the inventory into your supplier's warehouse to track the
quantities open with your vendor.

FINISHED GOODS

Finished goods are goods that have completed the manufacturing process but
have not yet been sold or distributed to the end user.

Manufacturing

Manufacturing has three classes of inventory:

1. Raw material
2. Work in process
3. Finished goods

A good purchased as a "raw material" goes into the manufacture of a

product. A good only partially completed during the manufacturing process
is called "work in process". When the good is completed as to manufacturing
but not yet sold or distributed to the end-user, it is called a "finished good".

Finished goods are a relative term. In a Supply chain management flow, the
finished goods of a supplier can constitute the raw material of a buyer

WORK IN PROGRESS

Work in process (WIP) or in-process inventory includes the set at large of

unfinished items for products in a production process. These items are not
yet completed but either just being fabricated or waiting in a queue for
further processing or in a buffer storage. The term is used in production and
supply chain management.

Optimal production management aims to minimize work in process. Work in

process requires storage space, represents bound capital not despoiled for
investment and carries an inherent risk of earlier expiration of shelf life of
the products. A queue leading to a production step shows that the step is
well buffered for shortage in supplies from preceding steps, but may also
indicate insufficient capacity to process the output from these preceding
steps.

Just-in-time (acronym: JIT) production is a concept to reduce work in

process with respect to a continuous configuration of product. Just in
Sequence (acronym: JIS) is a similar concept with respect to a scheduled
variety in sequence of configurations for products.
Barcode and RFID identification can be used to identify work items in
process flow. For locating the products additional requirements must be
considered to ensure not only presence of work items, but also knowledge of
the whereabouts of these items. This is a mandatory condition in flexible
production lines with paralleled work positions for single steps of
production.

WIP in construction projects

Work-In-Process in construction accounting identifies the value of
construction projects which are currently being worked on by the
construction firm. To properly account for each project, FOUR values are
needed for each project at the end of any given month (or period):

1. the Sales Price (excluding sales tax) for the project,

2. the total Cost Estimate for the project,
3. the Costs-To-Date,
4. The Billed-To-Date.

By taking the Costs-To-Date divided by the Cost Estimate, the "percentage

complete" for the project is calculated. For example:

 Assume a project is estimated to cost $70,000 by the time the

work is complete
 Assume at the end of December, $35,000 has been spent to date
for the project
 $35,000 divided by $70,000 is 50% therefore, the project
can be considered 50% complete at December 31.

Calculation of the Percentage complete is a valuable tool in determining how

much the client should be billed - it is important that Billings, and even
collection of these billings, are greater than the costs expended to do the
work. This ensures that the client is directly funding the construction work,
and that the contracting firm minimizes borrowing on behalf of the client.
Using the example above, suppose the following:

 the Sales Price of the project is $100,000

 $100,000 times 50% (the level of completion) = $50,000
Therefore, for the period ending December 31, the client should be invoiced
at least $50,000 to properly fund the work...

Inventory and Work In Progress (WIP)

When we talk about lean manufacturing we talk about inventory and work in
progress all the times. Lean and inventory are that close and therefore can
not be separated. Lean manufacturing identifies inventory and WIP as the
mirror of the imperfection system contain. Every imperfection creates a
requirement for WIP in manufacturing. Apart from being a great reflector to
the system imperfections, inventory becomes a waste by itself. Therefore
work in progress and inventory in general is classified as a waste in lean
waste classification.

With higher inventory, capital will be tied up. In simple words you get little
cash by selling goods after investing large amounts of money in
manufacturing it. Cost will be high since there are related costs like interests.
So either product will be sold with higher price tag or the organization will
loose money from its bottom line. Higher inventory and work in progress
hides the problems. Problems are hidden in higher work in progress and will
be not possible to remove from the system. For an example if we have one
day of work in progress with us, a part manufactured today will be used in
the next work station only tomorrow. If we start making a quality defect
today, only by tomorrow we will get to know about that. So we will loose
full one day of effort. Worst part is we have to redo it. This is almost three
times of the effort and cost.

In lean manufacturing context it is not possible simply to reduce or remove

inventory and work in progress from your system. Root cause to higher work
in progress is one of the other seven wastes we are discussing. So identifying
the correct root cause and treating them will reduce the WIP and higher
levels of inventory. Just in Time manufacturing, purchasing and distribution
techniques have a direct impact on the inventory levels. By using these
techniques with other techniques like root cause analysis you will be able to
reduce the inventory levels and avoid the problems identified.

In a lean office or in a lean service we can identify work in progress as

unfinished service requests from users. For an example work in progress can
be measured by the time taken to process an application or with the number
of applications in a work station to be processed. Higher the work to be
processed higher the process lead time. This can make costly delays to the
service requesters and in the organization. For an example if your marketing
office people couldn’t read a mail from your customer on the same day it
was sent how big the impact would be if the customer says he is going to
cancel the order to be processed on that day. Again mostly of the times
reasons for higher work in process in an office or a service are same as
explained in manufacturing. It will be a reflector of the problems you have
in your system. You can remove them with the lean techniques explained
throughout the blog and in this series of posts on lean and waste

In software development point of view inventory can be referred as

developments which are started but not finished. In a lean software
development environment software must be developed in small parts which
will be integrated to make the full product later. If we wait until the full
massive software is finished to test and deliver products it will take longer
and the timelines will be increased. Again work in progress is mainly
mirrors the imperfections the system contain. When you change the system
by applying lean techniques you will have lesser WIP and inventory of
work. You will be able to deliver good quality software fast.
REFERENCES:

1. www.google.com

2. www.yahoo.com

3. Wikipedia

4. Data from company’s previous records

5. Data collected from books.