Inventory

1
Inventory

• Overview
• Inventory Systems
• Cost Flow Assumptions
• Statement Analysis

2
Inventory

• Inventory Systems - Purpose
• To allocate the goods available for sale
  between cost of goods sold and ending
  inventory.
• Beginning Inventory Purchases Transportation
  Goods Available for Sale- Ending
  Inventory Cost of Goods Sold

3
Inventory

• Inventory Systems - Purpose
• To manage volume (units). To provide info about
  units sold and units remaining. To set
  production and reordering levels.
• To manage associated costs. To provide info re
  cost of goods sold and costs of units
  remaining. For decision-making re pricing, and
  financial statement preparation.

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Inventory

• Inventory Systems - general categories
• Physical Invy Systems- keep track of units, not
  costs. (e.g. to manage the reordering of new
  units of inventory in a large and varied invy.)
• Cost Invy Systems- keep track of units and
  costs associated with the units.(e.g. most
  easily implemented where invy items are uniquely
  identifiable - e.g. autos. However, improving IT
  (e.g. bar coding) is making these systems
  feasible to more co.s)

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Inventory

• Inventory Systems
• Choice of system depends on invy type, size,
  system implementation cost, and maintenance cost.

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Inventory

• Inventory Systems - two general types
• The perpetual system - has better and more
  timely info,(for pricing, reordering, etc.), but
  is costlier.- can identify shrink through
  matching of physical inventory counts to
  perpetual totals.- can link with EDI to reorder
  directly from the supplier.
• The periodic system- requires periodic physical
  inventory counts and costing to determine cost of
  goods sold.

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Inventory

• Inventory Systems - mixed
• Example of a mixed system- perpetual to track
  physical units and periodic to assign costs to
  units. (i.e. where of units is more important
  than cost.)

8
Inventory

• Inventory Systems - types
• The perpetual system - continually keeps track
  of units or their associated costs, or both.- at
  the time of sale, the unit(s) are removed from
  inventory.- the inventory ending balance can be
  calculated at any time.

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Inventory

• Inventory Systems - types
• The perpetual system (contd.)- cost of goods
  sold are always up-to-date in units or costs.-
  good for businesses with smaller inventories
  where there is a need to track unique items with
  item-specific costs.(autos)- still requires a
  physical count to check that perpetual balances
  are accurate. Shrinkage can, therefore, be
  identified. Count can be staggered so that all
  of the inventory need not be counted at the same
  time.

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Inventory

• Inventory Systems - types
• The periodic system - no entry to record
  inventory reduction at time of sale.- to
  determine amount sold and amount left in invy,
  business must shut down periodically (usually,
  once/year), to physically count the units left
  and to assign costs to them. Then, the COGS
  formula is used. (a physical count is a costly
  process - lost business, wages of counters.)

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Inventory

• Beginning Inventory Purchases Goods
  Available for Sale- Ending Inventory (Physical
  Count) Cost of Goods Sold

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Inventory

• Inventory Systems - types
• The periodic system (contd)- doesnt identify
  shrinkage (misplaced or stolen invy.)- other
  methods must be developed to establish reorder
  points.

13
Inventory

• Inventory Estimation
• Made when a count is not performed. (e.g. to
  prepare monthly income statements)
• One method is the gross margin estimation
  method- multiply the normal cost-to-sales
  ratio by the sales to arrive at estimated COGS.-
  then, use the COGS formula to work back into an
  estimated inventory value.

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Inventory

• Cost Flow Assumptions
• Costs must either be linked to units sold (COGS)
  or units remaining (ending invy.) to calculate
  both of these values.
• For businesses dealing in costly, unique items
  (e.g autos), the Specific Identification Method
  may be used to identify the cost of each unit in
  their invy.

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Inventory

• Cost Flow Assumptions
• Other businesses with higher volumes of like
  inventory items may find it difficult to identify
  specific costs with every invy item.
• Logical assumptions are made, in these
  businesses, about how costs flow through the
  organization. (note not physical flows).
• Besides Specific Identification, FIFO, LIFO, and
  Weighted Average methods are used.
• Applies to what happens with the COGS.

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Inventory

• Cost Flow Assumptions - FIFO
• First-in, first-out is the most common
  assumption used in Canada.
• Assigns the first costs to the first units sold.
• Therefore, the most recent purchases will be
  represented in the ending inventory -
  last-in, still-here (LISH).
• Closely describes the the physical flow of goods
  in most businesses.
• (see Exhibit)

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Inventory

• Cost Flow Assumptions - LIFO
• Last-in, first-out is not often used in Canada.
  
• Assigns the last costs to the first units sold.
• Therefore, the earliest purchases will be
  represented in the ending inventory -
  first-in, still-here (FISH).
• Like taking goods from the top of a bin and
  rarely reaching the bottom.
• (see Exhibit)

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Inventory

• Cost Flow Assumptions - LIFO (contd.)
• Problem is that cost of ending inventory is
  unrealistic (sometimes, well below market.)
• COGS includes the most recent cost. Therefore,
  is a good match to revenue of the period.
• Highest COGS, lowest net income. FIFO is
  vice versa.

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Inventory

• Cost Flow Assumptions - LIFO vs. FIFO
• Since both produce significantly different
  financial results, users of financial statements
  should know which is being used and why (i.e.
  managerial objectives).
• LIFO is the least used of 3 methods.
• It produces the lowest net income when costs are
  rising.
• Inventory balances become unrealistic.
• Not accepted by the Canada Revenue Agency (CRA)
  in calculating inventory for tax purposes.

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Inventory

• Cost Flow Assumptions - Weighted Average
• Computes an average cost for all the units
  available for sale in a period.
• Assigns the average cost to both the units that
  are sold and to those remaining in ending
  inventory.
• Produces results somewhere between FIFO and LIFO.
  (see Exhibit)
• Many co.s will use this for tax purposes and use
  FIFO for reporting purposes.

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Inventory

• Cost Flow Assumptions - Choice
• All 3 assumptions fit with GAAP.
• GAAP requires the co. to select the method that
  is the fairest matching of costs with revenues
  (regardless of the physical flow of inventory.)
• In periods of stable prices, all 3 assumptions
  would produce identical results.
• The same assumption does not have to apply to all
  inventories held by a company

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Inventory

• Cost Flow Assumptions - Choice
• Choice also depends on the objectives of
  management, the economic and, sometimes, the
  political environment. (e.g. in an environment
  of rising prices, LIFO provides the lowest
  profit FIFO the highest current ratio.)(e.g. in
  an environment of decreasing unit costs, FIFO
  would provide the lowest profit LIFO the highest
  current ratio.)

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Inventory

• Cost Flow Assumptions - Choice
• Due to the potential for LIFO to value
  inventories well below market, LIFO corporations
  often provide info in the footnotes to the
  financial statements to inform readers of the
  current cost of their inventories.

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Inventory

• Statement Analysis
• Users should know - the inventory assumption(s)
  being used by the company.- the type of
  inventory being sold and the effects of the
  economy on that inventory.
• Cross-industry analysis is most affected by use
  of cost flow assumptions.
• Trend analysis, within one company, will be
  unaffected if assumptions are applied
  consistently.

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Inventory

• Statement Analysis - Inventory Turnover Ratio
• Provides information about how fast the physical
  inventory turns over. Inventory Turnover
• Cost of Goods Sold
• Average Inventory
• If LIFO is used, numbers can be very distorted.
  However, very few co.s in Canada use LIFO.

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Inventory

• Statement Analysis - Other Considerations
• Users should know - choice of assumptions will
  impact the companys current ratio, profit
  percentages, etc.- differences between FIFO and
  LIFO will be magnified with greater fluctuations
  in unit costs and with an increasing number of
  years of application.