Name: Mary Lyn B.

Sernal Year&Course: BSBA 1G

Subject: Inventory Management and Control

CHAPTER THREE

Accounting and Finance for Inventories

Accounting for Inventories

3 Types of Inventory

1. Raw Materials- is made up of goods that will be used in production of finished products.
2. Wok-in-Process or WIP- consists of materials entered into the production process but not
yet completed.
3. Finished Goods Inventory – includes completed products waiting to be sold.

How Inventory is Valued

In order to assign a cost value to inventory, you must make some assumptions about the inventory on
hand.

There are 5 common inventory valuation methods.

1. First-in, First-out (FIFO)- this method mostly closely tied to actual physical flow of goods in
inventory.
Inventory valuation assumes that the first good purchased are the first to be used or sold
regardless of the actual timing of their use or sale.
2. Last-in, First out (LIFO)- inventory valuation assumes that the most recently
purchased/acquired goods are the first to be used or sold regardless of actual timing of their use or
sale.
Since items you have just bought often cost more than those purchased in the past, this method
best matches current cost with current revenues.
3. Average cost method- it identifies the value of inventory and cost of goods sold by calculating
an average unit cost for all goods available for sale during a given period of time.
This valuation method assumes that ending inventory consists of all goods available for sale.

Average cost = Total cost of goods available for sale ÷ Total quality of goods available for sale.

4. Specific Cost Method ( or actual cost method )- of inventory valuation assumes that the
organization can track the actual cost of an item unit, inventory and out of the facility.
Specific costing is generally used only by companies with sophisticated computer systems or
reserved for high-value items such as artwork or customer-made items.
5. Standard Cost Method- inventory valuation is often used by manufacturing companies to give
all their departments a uniform value for an item throughout a given year.
This method is a “best guess” based on known costs and expenses such as historical cost and any
anticipated changes coming up in the foreseeable future. It is a working tool more than a formal
accounting approach.
Inventory on the balance sheet
The balance sheet shows the financial position of a company on a specific date.

Provides basic accounting equation details for: Assets = Liabilities + Equity

Assets are the company’s resources while Liabilities and Equity are how those resources are paid for.

Assets represents company’s resources, form of cash or other items have monetary value (b) long term
asset’s such as investment and fixed assets (property/plant/equipment) or (c) intangible assets
(patents/copyrights/and goodwill.)

 Liabilities represents amount owned to creditors (debt, accounts payable, and lease-term
obligations.)
 Equity represents ownership or rights to the assets of the company (common stock, additional
paid in capital, and retained earnings.)

Know your ROI (return on investment)

ROI= REVENUE – EXPENSES

INVESTMENTS

Inventory is a typically counted among company’s current assets because it can be sold within a
year.

Note, however, that the balance sheet is not place that inventory plays a role in financial analysis, In
fact Inventory shows up on the income statement in the form of cost of good sold.

Inventory on the Income Statement

The income statement is a report that identifies a company’s revenues (sales), expenses, and resulting
profits.

Balance Sheet

While balance sheet can be described as a snapshot of a company on a specific date (June 30, for
example) the income statement covers a given period of time (June 1 through June 30).

The cost of goods sold is the item on the income statement that reflects the cost of inventory flowing out
of a business.

“You make money by using or selling inventory.”

Cost of good sold (on the income statement) represents the value of goods (inventory) sold during the
accounting period.

The value of goods that are not sold is represented by the ending inventory amount on the balance sheet
calculated:

Cost of good sold = Beginning inventory + Purchases – Ending Inventory

This information is also useful because it can be used to show how a company “officially” accounts for
Inventory. With it, you can back into the cost of purchases without knowing the actual costs by turning
around the equation as follows.
 Ending Inventory = Beginning inventory + Purchases – Cost of Goods Sold

Or you can figure out of goods sold if you know what your purchases are by working the following
calculation:

Purchase = Ending Inventory – Beginning inventory + Cost of Good Sold

Ratio analysis and what they mean.

Ration it is an expression of how many of one item is contained within another.

Ration can be used in the business world by selecting part’s of an organization’s financial statements and
comparing one set of financial condition’s to another.

A company’s financial statements contain key aspects of the business by reviewing this aspects you can
determine an organization’s economic well-being. One way of reviewing these financial condition’s is to
compare one to another through dividing one by the other.

Ratio are useful tools to explain trends and to summarize business results.

Third party such as banks use ratios to determine a company’s credit worthiness.

When compared to other industry and/or company-specific figures or standards, ratios can be more
powerful in helping to analyze your company’s current and historical results.

Allow current ratio may signal or has a problems or suffering from a lack of cash flow to cover operating
and other expenses in short-and long-term obligations.

Companies in the same industry often have similar liquidity ratios or benchmarks, as they often similar
cost structure’s . Your company’s ratios can be compared to:

1. Prior period (s)

2. Company goals or budget projections
3. Companies in your industry
4. Company in other industries
5. Companies in different geographic regions.

Three (3) ratios that are useful when assessing inventory.

1. Current Ratio – the current ratio assesses the organizations overall liquidity and indicates a
company’s ability to meet it’s short-term obligations.

It measures whether or not a company will be able to pay it’s bills. The current ratio indicates
how many dollars of assets we have for each dollar of liabilities that we owe. The current ratio is
calculated as follow: Current Ratio = Current Assets ÷ Current Liabilities.

Current assets refers to assets that are in the form of cash or that are easily convertible to cash
within one year, such as accounts receivable, securities, and inventory.

Current Liabilities refers to liabilities that are due and payable within twelve months, such as
accounts payable, notes payable and short-term portion of long-term debt.
 Standards for the current ratio vary from industry to industry.

What the current ratio might mean:

Allow current ratio may signal that a company has liquidity problems or has trouble meeting its short-
and long-term obligations. In other words, the organization might be suffering from a lack of cash flow to
cover operating and other expenses. As a result, accounts payable may be building at a faster rate than
receivables.

A High Current Ratio is not necessarily desirable, it might indicate company is holding high risk
inventory or may be doing a bad job of managing its assets.

High Current Ratio result of a very large cash account, it may be an indication that the company is not
reinvesting cash appropriately.

Even the ratio looks fine, other factors may must be taken consideration.

2. Quick Ratio or Acid Test. The quick ratio compares the organizations most liquid current assets
to its current liabilities. The quick ratio is calculated as follows:

Quick Ration=(Current Assets-Inventories)÷Current liabilities

Assume that the industry that sells on credit has a quick ratio of at least 0.8 on the company has at least 80
cents in liquid assets (likely in the form of accounts receivables) for every P1 of liabilities.

3. Inventory turnover ratio. The inventory turnover occurs every time an item is received, is use or
sold, and then is replaced.

Inventory turnover is an important measure’s since the ability to move inventory quickly directly impacts
the company’s liquidity. Inventory turnover is calculated as follow: Inventory Turnover Ratio= Cost of
Goods Sold ÷ Average Inventory

Essentially, when a product is sold, it is subtracted from inventory and transferred to cost of goods sold.
Therefore, this ratio indicates how quickly inventory is moving for accounting purposes.

A more accurate measure of how many times actual physical inventory turned within the site would be:

Actual physical inventory turnover ratio = Cost of Good Sold from Inventory Only ÷ Average
Inventory

Note that if inventory has increased or decreased significantly during the year, the average inventory for
the year may be skewed and not accurately reflect your turnover ratio going forward.

Also if the company uses the LIFO method of accounting, the ratio may be inflated because LIFO may
undervalue the inventory.

Unlike the current ratio and quick ratio, the inventory turnover ratio does not adhere to a standard range.

Obsolete Stock
Any stock keeper who has had to repeatedly move really slow moving or outright dead stock out of the
way or finds herself hurting for space because obsolete product eats up square foot after square foot
knows that these items “just gotta go”.

Why You Have Been Told Not to Dispose of it

Why is the dead stock is still here? Three reasons most often given as to why the product can’t be
disposed of are:

1. Its already paid for.

2. We might used it someday

3. We might sell it someday

Impact of Write Off

Anything that appears as an asset on the balance sheet has an accounting value. This value,
consisting of an items original cost minus depreciation, is called the “book value”. If your organization is
sensitive to making extraordinary adjustments to the balance sheet and never or seldom write of dead
inventory, may have a difficult time ever convincing any decision maker to dispose of these items. The
decision maker will simply not be willing to “take hit on the books”.

Organizations Capital Structure

Almost everyone has heard the expression “Cash is King”. It is the combination of your company’s
sources of finance. It includes equity share capital, debt, and vendor finance, to meet operational and
investment requirements.

Account Receivables

Are the amounts due from customers resulting from normal sales activities.

Banker will also lend against the book of value of inventory. The more complex nature of these
transactions comes from the fact that in Accordance with Accepted Accounting practices, WE
SHOULD VALUE INVENTORY AT THE LOWER OF COST OR FAIR MARKET VALUE.

Dead stock should logically be valued at a fair market value of zero dollar no matter what it
originally cost.

In spite of Generally Accepted Accounting practices and even through parts of your inventory have
no real market value (and should be valued at zero dollars ), banker will often loan your
organization 50 to 60 percent of the value of the inventory as the value is shown on the books.

Because of the R factor, modern purchasing dictates that you buy larger quantities on fewer
purchase orders, but with suppliers releasing items on a prearranged schedule or on demand.

Ultimately, the point at which your cost or carrying inventory matches the cost of purchasing it is
the proper economic order quantity of that item.