Read more
- Introduction to Cost and Management Accounting
- High/Low and Linear Regression Analysis
- Inventory Management
- Accounting for Inventory
- Accounting for overheads
- Absorption Costing
- Marginal Costing
- Job Batch and Service costing
- Process Costing
- Target Costing
- Variances
- Standard Costing
- Cost Volume Profit analysis
- Relevant costing and Decision-Making Techniques
- Time Value of Money (TVM)
Inventory Management Overview
Costs associated with inventory:
- Purchase Price.
- Re-order costs:
-
- cost of delivery of purchase items.
- cost associated with placing order.
- cost associated with checking the inventory after delivery.
- Inventory holding costs:
-
- capital tied-up.
- insurance costs.
- cost of warehousing.
- obsolescence, deterioration and thief.
- Shortage costs/Stock-out costs.
Changing inventory levels will affect variable holding costs but not fixed cost
Trade-off
There is a trade-off between ordering costs and holding costs:
- The holding costs reduces , as when average inventory falls as order size falls, thus increases order cost as there will be more number of orders. The inverse is also correct.
Economic Order Quantity (EOQ)
EOQ is a mathematical model used to calculate the quantity to order each time an order is made, in order to minimize the annual inventory costs.
Assumptions of EOQ
- There are no bulk purchases discount. All units purchased cost the same unit price.
- The order lead time/Re-order period (the time between placing an order and receiving delivery) is constant. and known.
- Annual demand is constant throughout the year.
Based on the assumptions; the relevant costs are the annual holding cost per item per annum and the annual ordering costs.
Formula to be used:
Economic order quantity
Q= 2COD
CH
Where;
Q = Quantity purchase in each order.
CO= Cost per order
CH= holding cost per item per annum
D = Annual Demand
- At EOQ total annual ordering costs and holding costs are always same.
- EOQ precludes safety inventory.
Other formulas: (if maximum inventory held is ‘Q’ i,e EOQ)
- Average inventory = Q/2
- Total holding costs = (Q/2) x CH
- No. of orders = D/Q
- Total ordering cost = (D/Q) x Co
Optimum order quantity with price discount for large orders
- EOQ formula uses to calculate purchase quantity and assumes purchase cost constant. Therefore purchase cost irrelevant.
- If a supplier offers a discount on the purchase price above a certain quantity. The purchase price becomes relevant.
- In this situation in order to minimize costs, compare;
-
- EOQ ; and
- Minimum ordering quantity necessary to obtain price discount.
The total costs must be calculated for both:
| EOQ | Quantity if discount obtained | |
| Annual ordering cost | x | x |
| Holding costs | x | x |
| Purchase costs | x | x |
| Total costs | xx | xx |
Decision: should be which order quantity minimizes total costs.
Inventory Valuation
Basic Rule:
Inventory must be measured at lower of;
- Cost; or
- Net realizable value (NRV)
It would be impossible to identify the actual cost for all inventory items because of the large numbers of such items.
Therefore, cost formulas are used for determining cost of group of similar items.
The following cost formulas are used:
- Large and expensive items are readily recognizable but cost of similar items are impossible to identify.
- To establish the cost of inventory using FIFO it is necessary to record:
| Received | Issued | ||||
| Date | Units | Price | Date | Units | Price |
- This approach assumes that the first inventory sold is always the inventory bought earliest date.
This means closing inventory is always assumed to be the most recent purchase.
- This approach assumes that all units are issued at the current weighted average cost per unit.
- A new average cost is calculated whenever more items are purchased and received in stores as:
Cost in store + New items cost
No. of units in stores + New units
Inventory Reorder level and other warning levels
When certain lead time and constant demand
When the demand is constant and lead time is certain, the Re-order level can be calculated as:
= Demand for material per day/week (multiply-by) lead time in days/weeks.
UN-certain demand and supply lead-time
Three warning levels of inventory
Maximum inventory level
Inventory held above this would incur extra holding cost without adding benefit to company.
It can be calculated as:
[Reorder level + Reorder quantity]
minus
[maximum demand per day/week x maximum supply lead time]
Re-order level
[maximum demand per day/week x maximum supply lead time]
Safety Inventory
- If supply lead time and demand is uncertain there should be a safety level of inventory (also called safety stock, Buffer stock):
- It is actually the average amount of inventory held in excess of average requirements.
It can be calculated as:
[maximum demand per day/week x maximum supply lead time]
minus
[average demand x average lead time]
When inventory falls below this amount, management should check that a new supply will be delivered before all the inventory is used up.
It can be calculated as:
[Reorder level]
minus
[average demand per day/week x average supply lead time]