1 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition, Chapter 8 Accounting for Inventory

Overview Accounting for Inventory Flow of costs Costing under weighted average, FIFO and other methods Job and process costing Long term contract costing Management accounting statements 2 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

What is inventory (or stock) Goods bought or manufactured for resale but unsold –Timing difference between production capacity and customer demand Valuation (IAS2) is the lower of cost or net realisable value –Effect on Income Statement & Statement of Financial Position Cost includes all costs of purchase or manufacture to bring inventory to its present location and condition 3 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Inventory & cost sales 4 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Types of inventory Inventory 1.Raw materials – pre-production 2.Work in progress - uncompleted 3.Finished goods – manufactured or purchased and ready for sale 5 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Flow of Costs in Purchasing 6 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Flow of Costs in Manufacturing 7 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cost formulae Differentiated products: specifically identifiable, not differentiated and not interchangeable – e.g. a vehicle to a car dealer –Actual cost for each item Similar/undifferentiated products –Weighted average –FIFO (first in, first out) –LIFO (last in, first out) 8 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Illustration A product is purchased on three separate occasions: UnitsUnit priceTotal cost 5,000£1.20£6,000 2,000£1.25£2,500 3,000£1.27£3,810 Calculate the cost of 6,000 units sold and the value of inventory 9 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Weighted average UnitsUnit priceTotal cost 5,000£1.20£6,000 2,000£1.25£2,500 3,000£1.27£3,810 10,000£12,310 The weighted average cost is £12,310/10,000 = £1.231 per unit. The cost of goods sold is £1.231 = £7,386 The value of inventory is £1.231 = £4, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

FIFO UnitsUnit priceTotal costCost of sales £6,000 £1,250 3,000£1.27£3, £7,250 UnitsUnit priceTotal cost Inventory value 5,000£1.20£6,000 £1,250 4,000 £5,060 Total £12, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Comparison of methods If 6,000 units £2.00 Sales£12,000 Cost of sales (WAM) 7,386 Gross profit 4,614 Sales£12,000 Cost of sales (FIFO) 7,250 Gross profit 4, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Retail method Large number of rapidly changing items with similar margins –Deduct appropriate profit margin from sales value of inventory e.g. sales value of inventory of tinned vegetables £1,000,000 Normal profit margin on sales of tinned vegetables 20% Cost of inventory under retail method £1,000,000 = £833, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Net realisable value Use if lower than cost Proceeds of sale, less costs of disposal Cost of product £15 Discounted sales price £12 but incurs transport cost of £2 Net realisable value: £10 – use this value as it is lower than cost Cost of product £15 Scrap value £8 – use this value as it is lower than cost 14 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Production methods Custom –Unique, single products Batch –A quantity of the same goods produced at the same time ( a production run) Continuous (or process) –Continuous production process of the same, indistinguishable goods 15 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Transaction recording in manufacture Material issues: record the quantity of material issued from raw materials to production. Timesheets: record the number of hours worked by production labour to convert the raw material to finished goods. Overheads: allocated (chapter 9) Conversion costs: labour + overhead 16 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Job costing illustration Helo manufactures components for helicopters. It does so in batches of 100 components. Each batch requires 500 kgs of rolled and formed steel, which takes 15 hours of labour. Transactions : Purchase of steel €12/kg Issue of steel to production 500 kgs Direct labour to roll and form 500 kgs steel 15 €125/hour Overhead allocated is €200 per direct labour hour. 60 of the components manufactured in the batch were sold for €130 each. At month end, but prior to the completion of the job, 500 kgs of steel had been issued to production and 7 hours had been worked.  Calculate the value of work in progress at month end. 17 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Work in progress will comprise Materials: Steel 500 €12/kg = €6,000 Labour: 7 € Overhead: 7 €200 1,400 Work in progress€8,275 Note: The job is charged with material issued NOT purchased 18 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

After completion of the job, calculate: –The unit cost of production –The gross profit –The value of inventory. 19 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

The job cost for the production of a batch of 100 components is as follows: Materials: Steel 500 €12/kg€6,000 Labour: 15 €125 1,875 Overhead 2,000 Total job cost€9,875 Cost per component(€9,875/100)€98.75 Cost of sales €98.75) = €5,925 Sales income €130) = €7,800 Gross profit is € €5925 = €1,875. Stock of finished goods €98.75) = €3,950 Stock of raw materials 500 kgs of €12/kg = €6,000 (purchased 1000kg less used 500kg) Total inventory€9,950 There is no Work in progress as the job is complete 20 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Job costing and work in progress for services Professional service firms have work in progress for unbilled hours PLC Accountants have been conducting ABC Limited’s audit. At month end 15 partner hours and 60 audit hours have been allocated to ABC’s work, which has not been invoiced. The hourly cost rates used by PLC are $200/hour for partners and $80/hour for managers.  Calculate the work in progress for PLC at month end. 21 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Work in progress: 15 partner $200$3, audit $80 4,800 Total$7,800 This reduces costs and appears in PLC Accountants’ Statement of Financial Position until it is invoiced to the client. 22 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Process costing illustration Voxic Ltd manufactures lubricants continuously. Transactions for the month: Raw materials costing £140,000 were purchased 100,000 litres of lubricant were produced. Materials issued to production cost £75,000 Conversion costs incurred were £55, ,000 litres of lubricant were sold for £1.50/litre.  At the end of month, calculate:  The unit cost of production  The gross profit  The value of inventory. 23 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cost of production (materials £75,000 + conversion £55,000) = £130, ,000 litres produced, cost per litre (£130,000/100,000 litres) = £1.30 Cost of sales for 80,000 litres sold £1.30) = £104,000 Sales £1.50) = £120,000 Gross profit (£120,000 - £104,000) = £16,000. Finished goods inventory (20,000 litres £1.30) = £26,000 Raw materials inventory (£140,000 purchased less £75,000 issued) = £65, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Process costing with partially completed units – weighted average Kazoo produces oils on a process basis during a month: Opening work in progress 7,000 units: –Materials € 12,000 and conversion costs € 30, ,000 units commenced production during the month. Closing work in progress 4,000 units, 75% complete. Cost of materials issued to production during the month was €140,000. Conversion costs for production during the month were €80, © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

 Calculate:  The number of units completed  The equivalent units in WIP  The cost per unit, using the weighted average method  The cost of work in progress and finished goods at month end. 26 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Note: In process costing examples, unless advised otherwise, assume that materials are added at the beginning of the process, and conversion costs are added uniformly throughout the process. 27 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Process costing: materials & conversion costs Material added Conversion costs applied uniformly Beginning of process End of process 28 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Calculate number of units completed Units Opening WIP 7,000 Units commenced12,000 19,000 Closing WIP 4,000 Completed15,000 Equivalent units: a measure of the resources used relative to the resources necessary to complete all units 29 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Calculate costs per unit 30 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Long term contract costing Construction contracts –Large units produced over longer periods –Apportion profits over accounting periods –AASB111: revenue and costs to be allocated in the periods over which the contract takes place Stage of completion method –Profit is based on the proportion of work carried out and costs matched with income 31 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Long term contract costing Architects certificate as to stage of completion Progress payments by customer Retention value 32 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Long term contract costing illustration Macro Builders has entered into a 2 year contract to construct a building. Contract price is $1.2 million, Expected cost of construction of $1 million. After 1 year, the following costs have been incurred: Material delivered to site$500,000 Salaries and wages paid 130,000 Overhead costs 170,000 Certification of value of work completed is $600,000. Macro estimates cost of $250,000 to complete over and above the costs already incurred.  Calculate:  The anticipated profit on the contract  The amount of profit that can be considered to have been earned to date. 33 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Long term contract costing illustration 34 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Management accounting statements Manufacturing statement Cost of sales statement Income statement 35 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Manufacturing statement 36 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Cost of sales statement 37 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Income statement 38 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Inventory valuation and decision-making Essential to value inventory for financial reporting purposes. Inventory costs may not be suitable for decision making purposes. –Assumptions and limitations of costs based on accounting standards have to be understood and questioned in terms of their relevance for day to day decision making 39 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,

Key points Accounting for Inventory Flow of costs between RM, WIP & FG Costing under different methods: especially weighted average & FIFO Job costing (manufacturing & services) Process costing Long term contract costing Management accounting statements 40 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 4th edition,