© 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 1

CHAPTER 7 Inventory Management © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 2

Learning Objectives How are inventories presented on a company’s financial statements? How does the flow of inventory costs differ between a manufacturing and a merchandising company? What are the various methods used to value inventory? How are these methods applied in practice? What are the benefits and challenges of just-in-time (JIT) inventory management? Why are inventory management practices important in controlling costs of inventory? © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 3

Introduction to Inventory Goods bought or manufactured for resale but unsold  Timing difference between production capacity and customer demand Cost includes all costs of purchase or manufacture to bring inventory to its present location and condition On a company’s statement of comprehensive income, the cost of inventories is recorded as “Cost of goods sold” and on the statement of financial position, it is reported under current assets as “Inventory.” 4 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Inventory for a Merchandising Company © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 5 Cost of Goods Sold: Merchandising Company

Inventory for a Merchandising Company © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 6 Statement of Comprehensive Income Statement of Financial Position

Inventory for a Merchandising Company © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 7 The Flow of Costs in Purchasing

Inventory for a Manufacturing Company Inventory types 1. Raw materials – unprocessed goods 2. Work in process – uncompleted goods 3. Finished goods – manufactured or purchased and ready for sale 8 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

9 Inventory for a Manufacturing Company Cost of Goods Manufactured: Manufacturing Company

10 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 Inventory for a Manufacturing Company Cost of Goods Sold Statement: Manufacturing Company

11 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 Inventory for a Manufacturing Company Statement of Comprehensive Income Statement of Financial Position

12 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 Inventory for a Manufacturing Company The notes to the financial statements would show a breakdown of the valuation of inventory in the current assets section of the statement of financial position.

13 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 Inventory for a Manufacturing Company The Flow of Costs in Manufacturing

Valuation of Inventory Lower of cost or net realizable value (NRV) Individually purchased inventory  Purchase cost is used to value the inventory and the cost of goods sold when the inventory is sold Similar/undifferentiated products (bulk)  Weighted average cost  FIFO (first in, first out) 14 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Example 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 goods sold for the 6,000 units sold and the value of the ending inventory 15 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Weighted Average Method for Merchandising Companies 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 the ending inventory is $1.231 = $4,924  Total cost $7,386 + $4,924 $12, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

First-In, First-Out Method for Merchandising Companies UnitsUnit priceTotal costCost of Goods Sold = = 3,000$1.27$3, $7,250 UnitsUnit priceTotal cost Ending Inventory Value 5,000$1.20$6,000 = = 4,000 $5,060 Total cost $7,250 + $5,060 $12, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Comparison of Methods Weighted Average Method If 6,000 units $2.00 Sales$12,000 Cost of goods sold (WAM) 7,386 Gross profit 4,614 FIFO Method Sales$12,000 Cost of goods sold(FIFO) 7,250 Gross profit 4, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Net Realizable Value (NRV) NRV is the potential proceeds of sale of inventory, less any costs of disposal If the NRV is lower than the recorded cost, the inventory item should be recorded at NRV 19 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Methods of Costing Inventory in Manufacturing Custom  Unique, single products Batch  A quantity of the same goods produced at the same time ( a production run) Continuous (Process Costing)  Continuous production process of the same, indistinguishable goods 20 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Job Order Costing Cost of raw materials as they are issued to each job (either a custom product or a batch of products) Plus the cost of time spent by different categories of labour To each of these costs, overhead is allocated to cover the fixed and variable manufacturing overheads that are not included in materials or labour (overhead will be explained in Chapter 11) Accumulated cost of materials, labour, and overhead is the cost of that custom product 21 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Job Costing Example Helo Ltd manufactures components for helicopters in batches of 100 components. Each batch requires 500 Kg of rolled and formed steel, which takes 15 hours of labour. July Transactions  Purchase of steel 1,000 $12/Kg  Issue of steel to production 500 Kg  Direct labour to roll and form 500 Kg steel 15 $125/hour  Overhead is allocated $2,000 at completion of batch.  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 Kg of steel had been issued to production and 7 hours had been worked. Calculate the value of work in process at month end 22 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Work in Process Materials: Steel 500 $12/Kg = $6,000 Labour: 7 $ Work in progress$6,875 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 23

At the completion of a batch of 100 components, calculate:  Total job cost  The unit cost per component  The gross profit  The value of  raw materials inventory  finished goods inventory  work in process inventory 24 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

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 Sales income $130) = $7,800 Cost of sales $98.75) = $5,925 Gross profit is $ $5925 = $1,875 Finished goods inventory $98.75) = $3,950 Raw materials inventory 500 Kg 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 25 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Process Costing Costs are collected over a period of time together with a measure of the volume of production At the end of the accounting period, the total costs are divided by the volume produced (equivalent units) to give a cost per unit of volume Equivalent units are the number of fully completed units in production © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 26

Process Costing Equivalent units measure the fully completed units by multiplying the number of units in the work-in-process inventory by their percentage of completion This amount is added to the finished units to determine the equivalent units © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 27

Either the weighted average method or the first- in, first-out (FIFO) method can be used to calculate inventory costs for process costing. Under both methods, it is necessary to complete three steps: 1. Determine the number of units completed. 2. Calculate the equivalent units in work in process and the cost per equivalent unit. 3. Assign the cost to finished goods and ending WIP inventory © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 28 Process Costing

Note: In process costing examples, unless you are advised otherwise, materials are assumed to be added at the beginning of the process, and conversion costs are added uniformly throughout the process. 29 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 Material added Conversion costs applied uniformly Beginning of process End of process

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:  55% completed  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, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

 Calculate:  The number of units completed  The equivalent units in WIP and the cost per equivalent unit, using the weighted average method  The cost of work in process and finished goods at month end. 31 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Calculation of Units Completed Units Opening WIP 7,000 Units commenced12,000 19,000 Closing WIP 4,000 Completed15, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Calculation of Equivalent Units and Cost per Unit * 4,000 units, 75% complete at end of month = 3,000 equivalent units 33 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Assignment of Costs Work in progress: Materials $8$32,000 Conversion $6.111$18,333 $50,333 Finished goods: 15,000 $14.111$211,666 Total costs$262,000* * Materials $12,000 + $140,000 + Conversion $30,000 + $80,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 34

Process Costing with Partially Completed Units – First-in First-Out (FIFO) Kazoo produces oils on a process basis during a month Opening work in progress 7,000 units:  55% completed  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, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

 Calculate:  The number of units completed  The equivalent units in WIP and the cost per equivalent unit, using the FIFO method  The cost of work in process and finished goods at month end. 36 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Calculation of Units Completed Units Opening WIP 7,000 Units commenced12,000 19,000 Closing WIP 4,000 Completed15, © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Calculation of Equivalent Units and Cost per Unit * units, 55% complete, 45% added in current month: 7,000 x 45% = 3,150 ** 4,000 units, 75% complete at end of month = 3,000 equivalent units 38 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Assignment of Costs Work in process: Materials $ $46,667 Conversion $5.6537$16,961 $63,628 Finished goods: Beginning WIP already completed$42,000 Beginning WIP finished $5,6537)$17,809 Units started and completed (8,000 $ ) $138,564 $198,373 Total costs $262,000* * Materials $12,000 + $140,000 + Conversion $30,000 + $80,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 39

Valuation of Inventory for Service Companies Professional service firms also have inventories. Accountants and lawyers are examples of firms with large work-in-process inventories, covering work carried out on behalf of clients but not yet invoiced. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 40

Just-In-Time Inventory Management Maintain minimal inventories (as close to zero as possible) to reduce inventory carrying costs, such as storage and materials handling costs, and to reduce the cost of obsolescence Advantages  Cost savings  Improved customer and employee satisfaction  Improved quality Disadvantages  Inability to predict demand  Strong reliance on suppliers © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 41

Backflush Costing Transfers the cost of materials from suppliers, along with conversion costs, to finished goods inventory when production of finished goods is complete (the trigger point) The Flow of Costs in Backflush Costing 42 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Long-Term Contract Costing Large units produced over longer periods Percentage of completion  Revenues and gross profit are recognized in the applicable periods of production, not when production has been completed.  The costs incurred in reaching the relevant stage of completion are then matched with income 43 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Architects certificate as to stage of completion Progress payments by customer Retention value 44 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 Long-Term Contract Costing

Long-term Contract Costing Example 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. 45 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Anticipated Profit Costs of construction: Material delivered to site$500,000 Salaries and wages paid 130,000 Overhead costs 170,000 $800,000 Less work not certified 200,000 Cost of work certified$600,000 Anticipated profit: Cost of work certified$600,000 Work not certified 200,000 Estimated cost to complete 250,000 Currently estimated cost 1,050,000 (budget $1 million) Contract price1,200,000 Anticipated profit $150,000 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 46

Profit to Date Expected cost of construction $1,050,000 Certified as complete $ 600,000 Percentage complete 57% ($600,000/$1,050,000) Anticipated profit$ 150,000 Recognise profit of 57% of $150,000 = $85,500 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 47

Inventory Management Objective is to optimize the levels of inventory  Reduce costs associated with ordering and carrying inventories  Ensuring there is enough inventory on hand to meet consumer demand Costs associated with ordering and carrying inventory 1. Ordering costs 2. Carrying costs. 3. Stockout costs. 48 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7

Economic Order Quantity and Lead Times Economic order quantity (EOQ)  Determine the levels of inventory that will reduce costs while meeting demand Lead time  Time between when an order is placed with a supplier and when it is needed Safety stock  an amount of extra stock that is kept on hand to cover any unexpected increases in demand © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 49

Economic Order Quantity © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7 50 Calculated using the following formula

Conclusion Several methods of calculating the value of inventory and cost of goods sold How inventories are reported on the financial statements for a company Looked at the two main methods of costing inventories, job costing and process costing A method of long-term contract costing Benefits and challenges of using just-in-time (JIT) inventory management practices Economic order quantity can be used to optimize inventory costs. 51 © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 7