CHANAKYA NATIONAL LAW UNIVERSITY

PROJECT REPORT: INVENTORY VALUATION AND MANAGEMENT SUBMITTED TO : MR. JYOTIRMOY CHAKRAVORTY SUBMITTED BY : RAMDEV RAJPUROHIT ROLL NO. 1039 B.B.A.LL.B (HONS) SEM- 1ST

Acknowledgement :
Writing a project is one of the most significant academic challenges I have ever faced. Though this project has been presented by me but there are many people who remained in veil, who gave their all support and helped me to complete this project. I am very thankful to the librarian who provided me several books on this topic which proved beneficial in completing this project. I acknowledge my friends who gave their valuable and meticulous advice which was very useful and could not be ignored in writing the project, and special reference to Aniket Sourav, Shashi and Suyash who helped me in research work for project.

Ramdev Rajpurohit Roll No. 1039 1st semester

INDEX

Abstract.5 Introduction..5 Objective And Scope ...5 Defination..6 Types Of Inventories Measurement / Valuation Of Inventories 7 Valuation Of Inventory For Balance Sheet Purpose................................8 Principle Of Consistency And Inventory Valuation.....................9 Identification Of Old, Absolute And Non-Moving Stock.9 Reasons For Holding Inventories...9 Methods Of Inventory Valuation..10 Recording Of Inventory Values- Store Ledger Records12 Advantages Of FIFO And AVCO.............................12 Disadvantages Of FIFO And AVCO13 Comparison Between FIFO And AVCO Method..13 Categories Of Inventory............................14 Inventory Counts And Reconciliation..........................15 Average Cost...16 Base Stock..17 Inflated Price Method...........................18 Determination Of Stock Levels............................18
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Inventory System22 Effect Of Errors In Inventory Valuation23 Inventory Management System...........................25 Summary............................26

Abstract
The basic financial purpose of a firm is to maximize its value. An inventory management system should also contribute to realization of this basic aim. Many current asset management models currently found in financial management literature were constructed with the assumption of book profit maximization as basic aim. However these models could lack what relates to another aim, i.e., maximization of enterprise value.

Introduction
The basic financial aim of an enterprise is maximization of its value. At the same time, a large both theoretical and practical meaning has the research for determinants increasing the firm value. Most financial literature contains information about numerous factors influencing the value. Among those factors is the net working capital and elements creating it, such as the level of cash tied in accounts receivable, inventories and operational cash balances. A large majority of classic financial models proposals, relating to the optimum current assets management, were constructed with net profit maximization in view. In order to make these models more suitable for firms, which want to maximize their value, some of them must be reconstructed. In the sphere of inventory management, the estimation of the influence of changes in a firm's decisions is a compromise between limiting risk by having greater inventory and limiting the costs of inventory. It is the essential problem of the corporate financial management. The basic financial inventory management aim is holding the inventory to a minimally acceptable level in relation to its costs. Holding inventory means using capital to finance inventory and links with inventory storage, insurance, transport, obsolescence, wasting and spoilage costs. However, maintaining a low inventory level can, in turn, lead to other problems with regard to meeting supply demands.

Objective And Scope

A primary issue in accounting for inventories is the determination of the value at which inventories are carried in the financial statements until the related revenues are recognized. This Standard deals with the determination of such value, including the ascertainment of cost of inventories and any write-down thereof to net realizable value.

Scope
1. This Standard should be applied in accounting for inventories other than: (a) work in progress arising under construction contracts, including directly related service contracts (see Accounting Standard (AS) 7, Construction Contracts); (b) work in progress arising in the ordinary course of business of service providers;
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(c) shares, debentures and other financial instruments held as stock-in-trade; and (d) producers inventories of livestock, agricultural and forest products, and mineral oils, ores and gases to the extent that they are measured at net realizable value in accordance with well established practices in those industries. 2. The inventories referred to in paragraph 1(d) are measured at net realizable value at certain stages of production. This occurs, for example, when agricultural crops have been harvested or mineral oils, ores and gases have been extracted and sale is assured under a forward contract or a government guarantee, or when a homogenous market exists and there is a negligible risk of failure to sell. These inventories are excluded from the scope of this Standard.

Defination
The following terms are used in this Standard with the meanings specified: 1. Inventories Are Assets (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. 2. Net Realization Method Net realizable value is the estimated selling price in the ordinary course of business less the estimated costs of completion and the estimated costs necessary to make the sale. Inventories encompass goods purchased and held for resale, for example, merchandise purchased by a retailer and held for resale, computer software held for resale, or land and other property held for resale. Inventories also encompass finished goods produced, or work in progress being produced, by the enterprise and include materials, maintenance supplies, consumables and loose tools awaiting use in the production process. Inventories do not include machinery spares which can be used only in connection with an item of fixed asset and whose use is expected to be irregular; such machinery spares are accounted for in accordance with Accounting Standard (AS) 10, Accounting for Fixed Assets.

Types of Inventories Measurement / Valuation of inventories

Inventories should be valued at the lower of cost and net realizable value. 1. cost of inventories The cost of inventories should comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition. 2. cost of purchase The costs of purchase consist of the purchase price including duties and taxes (other than those subsequently recoverable by the enterprise from the taxing authorities), freight inwards and other expenditure directly attributable to the acquisition. Trade discounts, rebates, duty drawbacks and other similar items are deducted in determining the costs of purchase. 3. cost of conversion The costs of conversion of inventories include costs directly related to the units of production, such as direct labor. They also include a systematic allocation of fixed and variable production overheads that are incurred in converting materials into finished goods. Fixed production overheads are those indirect costs of production that remain relatively constant regardless of the volume of production, such as depreciation and maintenance of factory buildings and the cost of factory management and administration. Variable production overheads are those indirect costs of production that vary directly, or nearly directly, with the volume of production, such as indirect materials The allocation of fixed production overheads for the purpose of their inclusion in the costs of conversion is based on the normal capacity of the production facilities. Normal capacity is the production expected to be achieved on an average over a number of periods or seasons under normal circumstances, taking into account the loss of capacity resulting from planned maintenance. The actual level of production may be used if it approximates normal capacity. The amount of fixed production overheads allocated to each unit of production is not increased as a consequence of low production or idle plant. Unallocated overheads are recognized as an expense in the period in which they are incurred. In periods of abnormally high production, the amount of fixed production overheads allocated to each unit of production is decreased so that inventories are not measured above cost. Variable production overheads are assigned to each unit of production on the basis of the actual use of the production facilities. A production process may result in more than one product being produced simultaneously. This is the case, for example, when joint products are produced or when there is a main product and a by-product. When the costs of conversion of each product are not separately identifiable, they are allocated between the products on a rational and consistent basis. The allocation may be based, for example, on the relative sales value of each product either at the stage in the production process when the products become separately identifiable, or at the completion of production. Most by-products as well as scrap or waste materials, by their nature, are immaterial. When this is the case, they are often measured at net realizable value and this value is deducted from the cost of the main product. As a result, the carrying amount of the main product is not materially different from its cost.

4. other cost Other costs are included in the cost of inventories only to the extent that they are incurred in bringing the inventories to their present location and condition. For example, it may be appropriate to include overheads other than production overheads or the costs of designing products for specific customers in the cost of inventories. Interest and other borrowing costs are usually considered as not relating to bringing the inventories to their present location and condition and are, therefore, usually not included in the cost of inventories. 5. exclusion of cost of inventories In determining the cost of inventories in accordance with paragraph 6, it is appropriate to exclude certain costs and recognize them as expenses in the period in which they are incurred. Examples of such costs are: (a) abnormal amounts of wasted materials, labor, or other production costs; (b) storage costs, unless those costs are necessary in the production process prior to a further production stage; (c) administrative overheads that do not contribute to bringing the inventories to their present location and condition; and (d) selling and distribution costs.

Valuation of Inventory for balance sheet purpose

The most generally accepted accounting principle for valuation of inventory is that stock should be valued at cost or market price, whichever is lower. This flows from the Accounting Principle of Conservatism. As per the principle of conservatism, recognize all possible losses and anticipate no profit. Inventory should be valued at cost or market price (net realizable value), whichever is lower. Recognize all possible losses in respect of transactions and events that have happened. Do not recognize anticipated profits, however certain they are, till they are realized. 1. Cost: Cost is the expenditure incurred for bringing the inventory to the place and condition in which the goods concerned are to be sold. So, it is not only the purchase price, but also cost of conversion and other costs incurred in bringing the inventories to the present location and condition. Examples to the later category are wages or manufacturing expenses incurred for converting raw materials into finished goods, transportation costs, duties paid and insurance, etc. However, selling expenses and storage expenses are to be excluded.

2. Market Price: Market price means net realizable value, in case of finished goods and replacement price, in case of raw materials and chief stores. The net realizable value is to be calculated after considering all the expenses, which might have to be incurred for making sales. For example, if the seller has to pay commission of 10% of sales, the net realizable value of an article having a selling price of Rs. 100 is to be taken as Rs. 90. As per International Accounting Standard (IAS) No. 2, cost or market price method is to be followed for each item or group of homogeneous items of inventory.

Principle Of Consistency And Inventory Valuation

If the method of inventory valuation is changed from year to year, the results for two periods becomes incomparable. It will affect the true and fair view of the financial statements. However if a change in method is necessary for better presentation of financial results, it can do so. Hence it is very important to understand a companys policy of inventory valuation while interpreting the financial results.

Identification Of Old, Absolute And Non-Moving Stock

To ensure that stocks reflect assets having realizable value, old, non-moving and obsolete stocks should be identified and scrapped periodically and such loss must be recognized in the financial statements.

Reasons For Holding Inventories

There are six basic reasons for keeping an inventory 1. Time - The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amounts of inventory to use in this lead time. However, in practice, inventory is to be maintained for consumption during 'variations in lead time'. Lead time itself can be addressed by ordering that many days in advance. 2. Uncertainty- Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. 3. Economies of scale - Ideal condition of "one unit at a time at a place where a user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory.

4. Appreciation in Value - In some situations, some stock gains the required value when it is kept for some time to allow it reach the desired standard for consumption, or for production. For example; beer in the brewing industry. 5. To facilitate the production process - Stock can allow the manufacturing process to flow smoothly and help the business to respond quickly and effectively to contingencies. 6. Some processes require holding work in progress - Inventory can also include work in progress. Some products might have longer production cycles than others (like wine or cheese for instance). It is necessary to hold a high volume of inventory to cater for the inherent nature of production in some business contexts. All these stock reasons can apply to any owner or product

Methods of Inventory Valuation

The difficulty in inventory valuation is in finding out the cost price of inventory this is not easy when quantities of a particular inventory item are continually being bought in often at different prices and then sold. Some companies have inventory in a number of different forms, e.g. a manufacturer may well have raw materials, work-in-progress and finished goods. IAS 2, Inventories , allows companies to use one of two methods to calculate the cost price of their inventory: 1. FIFO First-In, First-Out (FIFO) is one of the methods commonly used to calculate the value of inventory on hand at the end of an accounting period and the cost of goods sold during the period. This method assumes that inventory purchased or manufactured first is sold first and newer inventory remains unsold. Thus cost of older inventory is assigned to cost of goods sold and that of newer inventory is assigned to ending inventory. The actual flow of inventory may not exactly match the first-in, first-out pattern. First-In, First-Out method can be applied in both the periodic inventory system and the perpetual inventory system. 2. AVCO In this method, the weighted average cost of items held at the beginning of the year is calculated, using the formula: weighted average cost = total cost of goods in inventory /number of items in inventory The weighted average cost is then used to value goods sold. A new weighted average cost must be calculated each time that further inventories are bought during the year. Note that the use of a particular valuation method does not necessarily correspond with the method of physical distribution adopted in the stores of the business. For example, in a car factory one car battery of type X is the same as another, and no-one will be concerned if the storekeeper issues one from the last batch received, even if
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the FIFO system has been adopted. However, perishable goods are always physically handled on the basis of first in, first out, even if the inventory records use the AVCO method. Having chosen a suitable inventory valuation method, a business would continue to use that method unless there were good reasons for making the change. This is in line with the consistency concept of accounting. 3. LAST IN FIRST OUT (COMMONLY CALLED LIFO) This method operates in just reverse order of FIFO method. As against the First in First Out method, the issues under this method are priced in the reverse order of purchase i.e., the price of the latest available consignment is taken first. Thus, the price of the last batch of materials purchased is used for all issues until all units from this batch have been issued. Later, the price of the previous batch received is used. It should be noted that physical flow of materials may not conform to LIFO assumption. This method is suitable in times of rising prices because material will be issued from the latest consignment at a price, which is closely related to current price levels, as far possible. Three points should be noted regarding this method: (a) Materials issues are priced at actual cost. (b) Charge to production for material cost is at the latest prices paid. (c) Closing stock valuation is at the oldest prices paid and is completely out of line with the current prices. Advantages: (1) Easy to operate: Like FIFO method, this is simple to operate and is useful when transactions are not too many and the prices are fairly steady. (2) No unrealized profit: Under this method, actual cost of materials is charged to production. So, this method, like FIFO, does not result in any unrealized profit or loss. (3) Prices reflect current market prices: Materials are charged to production at the latest prices paid. Thus, effect of current market prices of materials is reflected in the cost of sales, provided the materials are recently purchased. In times of rising prices, quotation of prices for companys products will be competitive and profitable. Disadvantages This method suffers from the following disadvantages: 1. Unrealistic method: This method is not realistic as it does not conform to the physical flow of materials. In physical flow of materials, first in first out method is followed. 2. Lacks comparison: Like FIFO, comparison between one job and the other job will become difficult because one job started a few minutes after another of the same type may bear different cost of materials. Similar jobs may differ because materials were issued from different lots and thus at different prices.
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3. Valuation of closing stock: The closing stock is valued at the old prices and does not represent the current economic values. Consequently, closing stock will be understated in the Balance Sheet. 4. Cumbersome calculation: This method is cumbersome when prices are subject to frequent fluctuations. Like FIFO, this method may lead to clerical errors. Every time an issue is made, the store ledger clerk will have to go through his record to ascertain the price to be charged. 5. More than one price: For pricing a single issue, more than one price has often to be adopted. Impact during rising prices/falling prices: Under the LIFO method, in times of rising prices, profits and taxes would be lower than under FIFO method. In periods of falling prices, the closing stock would be valued at higher price and thus the profits and taxes would also be higher. It is difficult to generalize about the superiority of any method, be it LIFO or FIFO. Each issue method has its own advantages as well as disadvantages. The actual utility of the method depends upon the prevailing circumstances.

Recording of Inventory Values- Store Ledger Records

In order to be able to calculate accurately the price at which materials are issued and to ascertain a valuation of inventory, a stores ledger record or inventory card is used, as shown below. This method of recording inventory data is also used in the Worked Example which follows. STORES LEDGER RECORD Note the following points: 1. the layout of the stores ledger record or inventory card may vary slightly from one business to another 2. many businesses use a computer system for their inventory records. 3. a blank stores ledger record, which may be photocopied, is available for free download from the Resources section of www.osbornebooks.co.uk 4. whilst it is good learning practice to use a stores ledger record, many examination questions require a calculation of inventory value this can be completed without a stores ledger record.

Advantages of FIFO and AVCO

FIFO (first in, first out) advantages 1. 2. 3. 4. 5. 6. it is realistic, i.e. it assumes that goods are issued in order of receipt it is easy to calculate inventory valuation comprises the actual costs at which items have been bought the closing inventory valuation is close to the most recent costs it is one of the two methods which IAS 2, Inventories , allows companies to use acceptable for tax purposes

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AVCO (average cost) advantages 1. over a number of accounting periods reported profits are smoothed, i.e. both high and low profits are avoided 2. fluctuations in purchase costs are evened out so that issues per unit do not vary greatly 3. logical, i.e. it assumes that identical units, when purchased at different times, have the same value 4. closing inventory valuation is close to current market values (in times of rising prices, it will be below current market values) 5. the calculations can be computerized more easily than the other methods 6. it is one of the two methods which IAS 2, Inventories , allows companies to use 7. acceptable for tax purposes

Disadvantages of FIFO and AVCO

Disadvantages FIFO 1. costs at which goods are issued are not necessarily the latest prices, so cost of sales may not represent current prices 2. in times of rising prices, profits are higher than with other methods (resulting in more tax to pay) 3. the method is cumbersome as the list of different costs must be maintained Disadvantages AVCO 1. a new weighted average has to be calculated after each receipt, and calculations may be to several decimal places 2. because they are averaged, issues and inventory valuation are usually at costs which never existed 3. issues may not be at current costs and, in times of rising prices, will be below current costs The important point to remember is that a business must adopt a consistent inventory valuation policy, i.e. it should choose a method of finding the cost price, and not change it without good reason. FIFO and AVCO are the two methods allowed under IAS 2, Inventories , and a company might decide to use FIFO for one type of inventory and AVCO for another. The table on the next page provides a comparison of the FIFO and AVCO methods of inventory valuation. Note that the two methods are simply valuation techniques and do not affect the cash generated by the business, or the way in which the goods are physically moved.

Comparison between FIFO and AVCO method

1. Method AVCO does not relate issues to any particular batch of goods received, but uses a weighted average cost. FIFO The costs used for goods sold or issued follow the order in which the goods were received.
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2. Calculation AVCO More complex because of the need to calculate weighted average costs. FIFO It is easy to calculate costs because they relate to specific receipts of goods. 3. Inventory Valuation AVCO Weighted average costs are used to value closing inventory. FIFO Inventory valuations are based on the most recent costs of goods received. 4. Acceptability Under Accounting Standards AVCO is acceptable under IAS 2, Inventories. FIFO is acceptable under IAS 2, Inventories. 5. Profits And Taxation AVCO, by using a weighted average cost, smoothes out some of the peaks and troughs of profit and loss. This method is acceptable for tax purposes. FIFO In times of rising prices FIFO results in higher reported profits than AVCO, resulting in more tax being payable. This method is acceptable for tax purposes. 6. Administration AVCO There is no need to track each receipt as a weighted average cost is used. This also means it is easier to computerize the inventory records. FIFO Use of FIFO will mean keeping track of each receipt of inventory until the goods are issued. This can be a time-consuming process. 7. Cost Of Sales AVCO gives an average price for goods issued and cost of sales. FIFO In a time of rising prices FIFO uses older, out of date prices for goods issued and cost of sales.

Categories of Inventory
IAS 2, Inventories, requires that, in calculating the lower of cost and net realizable value, note should be taken of: separate items of inventory, or groups of similar items This means that the inventory valuation 'rule' must be applied to each separate item of inventory, or each group or category of similar inventories. The total cost cannot be compared with the total net realizable value, as is shown by the Worked Example which follows

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Inventory counts and reconciliation

The Inventory Count A company needs to check regularly that the quantity of inventory held is the same as that recorded in the inventory records. This is done by means of an inventory count counting the physical inventory on hand to check against the balance shown by the records, and to identify any theft or deterioration. Inventory counting is carried out on either a periodic basis or continuously. A periodic basis involves carrying out an inventory count of all items held at regular intervals (often twice a year). Continuous inventory counting is a constant process where selected items are counted on a rotating basis, with all items being checked at least once a year (expensive, desirable or high-turnover items will need to be checked more frequently). Inventory Reconciliation The object of the inventory count is to see if the inventory records represent accurately the level of inventory held. The comparison between the inventory count and the inventory record is known as inventory reconciliation. This is an important process because 1. an accurate inventory figure can then be used to value the inventory 2. it will highlight any discrepancies which can then be investigated Discrepancies and queries in inventory reconciliation need to be referred to the companys managers and any other people who may need to know, e.g. the firm's auditors who are organizing the inventory count. If the discrepancy is a small shortfall in the physical inventory compared with the inventory record, it will be authorized for write-off. Larger discrepancies will need to be investigated, as they could have been caused by: a. an error on the inventory record, such as a failure to record a receipt or an issue of goods an administrative error, e.g.. 100 items received recorded as 10 items different items issued to those recorded, e.g.. a size 8 issued instead of a size 10 an error in calculating the balance of inventory. b. theft of inventory c. damaged inventory being disposed of without any record having been made Once an accurate figure for closing inventory has been agreed it can then be used in the financial statements to calculate profit, and for the balance sheet.

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Average Cost
In stores, material is always mixed up. The principal on which the average cost method is based is that all of the materials in store are so mixed up that an issue cannot be made from any particular lot of purchases. Therefore, it is proper, if the materials are issued at the average cost of materials in store. Average may be of two types: 1. Simple Arithmetic Average. 2. Weighted Arithmetic Average. 1. Simple Average Cost Simple Average Cost Simple average price is calculated by dividing the total of unit purchase prices of different lots in stock on the date of issue by the number of prices used in the calculation. Quantity of different lots is ignored. Suppose, following are three different lots of materials in stock when the materials is to be issued: 1,000, units purchased @Rs.10 2,000, units purchased @Rs.11 3,000, units purchased @Rs.12 In this example, simple average price will be Rs. 11 calculated as below:- 10+11+12/ 3= 11 Simple average price ignores the quantities for calculating the issue price. Does not recover full cost: Simple average price is not to be followed because this method of calculating issue price does not recover the full cost price of the materials. In the above example, the purchase price of the material in stock is Rs. 68,000 (1,000 10 + 2,000 11 + 3,000 12) whereas the recovery from the production according to simple average price method will be Rs. 66,000 (quantity 6,000 units issued @ Rs. 11 per unit). Thus, there is under recovery of Rs. 2,000 (Rs. 68,000 Rs. 66,000). Simple average price is not a proper method for issuing the prices as this method does not recover the full costs, which is the primary requirement of a good pricing method. 2. Weighted Average Cost Weighted Average Cost The weighted average price takes into account the price and quantity of the materials in store. In the above example, the weighted average price is Rs. 11.33 per unit calculated as follows: 1,00010 + 2,00011+ 3,000 12/ 1,000 + 2,000 + 3,000 = Rs. 11.33 It is better to issue the material at weighted average price method. This method recovers the full cost price of the materials from production. In the above example, the total purchase price of the materials in stock is Rs. 68,000 and the charge to jobs or work orders is also Rs. 68,000 (6,000 units@ Rs. 11.33). In periods of heavy fluctuations in the prices of materials, the weighted average cost method gives better results because it evens out fluctuations in price by taking the average of prices of various lots in stock.
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Advantages (1) Best method even when prices fluctuate: Weighted Average price method is considered to be the best method when prices fluctuate, considerably, because this method tends to smooth out fluctuation prices. (2) Simple calculation: Issue prices are not to be calculated each time issues are made. Issue prices are changed only when new lot of materials is received. (3) Full recovery of cost: This method recovers the cost of materials from production. (4) Issue prices near to market prices: This method maintains the issue prices as near to the market price as possible. (5) No adjustments in stock ledger: This method eliminates the necessity for adjustments in stock valuation. Disadvantages New calculation with every receipt: The greatest disadvantage of this method is that a fresh rate calculation has to be made as soon as a new lot of materials are purchased which may involve tedious calculations. Thus, there are chances of clerical errors. Weighted average cost method is used by most organizations because it satisfies most of the conditions of a good method of valuing material issues.

Base stock
Each concern always maintains a minimum quantity of material in stock. This minimum quantity is known as safety or base stock and this should be used only when an emergency arises. The base stock is created out of the first lot of the material purchased and therefore, it is always valued at the cost price of the first lot and is carried forward as a fixed asset. This method works with some other method and is generally used with FIFO or LIFO method. Therefore, the advantages and disadvantages of the method, with which the Base stock method is used, will arise. Any quantity over and above the base stock is issued in accordance with the other method, which is used in conjunction with this method. The objective of this method is to issue the material according to the current prices. This objective will be achieved only when the LIFO method is used together with the Base Stock method. Base Stock Method is always used in conjunction with FIFO or LIFO method. So, Base Stock Method would have the same advantages and disadvantages of the combined method FIFO or LIFO method.

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Inflated Price method

There are some materials, which are subject to natural wastage. Examples are: (1) Coal lost due to loading and unloading and (2) Timber lost due to seasoning. In such cases, the materials are issued at an inflated price (a price higher than the actual cost) so as to recover the cost of natural wastage of materials from the production. In this way, the total cost of the material is recovered from the production. For example, if 1,000 tons of coal are purchased at Rs. 75 per ton and if it is expected that 5 tons of coal will be lost due to loading and unloading, the inflated issue price in this case will be 1,00075 Rs.75.37 995 = per ton With the actual issue of 995 tons of coal, the actual cost of Rs. 75,000 (1,000 tons purchased @Rs.75 per ton) will be recovered from production (995 tons @Rs. 75.37).

Determination Of Stock Levels

1. Maximum Level Or Maximum Limit The maximum stock limit is upper level of the inventory and the quantity that must not be exceeded without specific authority from management. In other words, the maximum stock level is that quantity of material above which the stock of any item should not normally be allowed to go. This level is fixed after taking into account such factors as: capital, rate of consumption of materials, storage space available, insurance cost, risk of deterioration and obsolescence and economic order quantity. Formula: Maximum level or maximum limit can be calculated by the help of following formula: Maximum limit or level = Re-order level or ordering point Minimum usage Minimum re-order period + Economic order quantity Example:

Normal usage Maximum usage Minimum usage Re-order period Economic order quantity

100 units per day 130 units per day 70 units per day 25 to 30 days 5,000 units

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Calculate maximum limit or level. In order to calculate maximum limit of stock we must calculate re-order point or re-order level first. Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum re-order = 130 30 = 39,000 units Calculation: Maximum limit or level = Re-order level or ordering point Minimum quantity used in re-order period usage + Economic order quantity = 3900 (70 25) + 5,000 = 7150 units

2. Minimum Limit Or Minimum Level Of Stock The minimum level or minimum stock is that level of stock below which stock should not be allowed to fall. In case of any item falling below this level, there is danger of stopping of production and, therefore, the management should give top priority to the acquisition of new supplies. Formula: Minimum level or minimum limit can be calculated by the following formula or equation: Minimum limit or level = Re-order level or ordering point Average or normal usage Normal re-order period Or the formula can be written as: Minimum limit or level = Re-order level or ordering point Average usage for Normal period Example: Normal usage Maximum usage Minimum usage Re-order period

100 units per day 130 units per day 70 units per day 25 to 30 days

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Calculate: minimum limit or level To calculate minimum limit of materials we must calculate re-order point or re-order level first. Calculation: Ordering point or re-order level = Maximum daily or weekly or monthly usage Maximum re-order = 130 30 = 3,900 units Minimum limit or level = Re-order level or ordering point Average or normal usage Normal re-order period = 3900 (100 27.5*) 1150 units *(25 + 30 ) / 2

Average Inventory Calculation Average inventory is used to estimate the amount of inventory that a business typically has on hand over a longer time period than just the last month. Since the inventory balance is calculated as of the end of the last business day of a month, it may vary considerably from the average amount over a longer time period, depending upon whether there was a sudden draw-down of inventory or perhaps a large supplier delivery at the end of the month. Average inventory is also useful for comparison to revenues. Since revenues are typically presented in the income statement not only for the most recent month, but also for the year-to-date, it is useful to also calculate the average inventory for the year-to-date, and then match the average inventory balance to year-todate revenues, to see how much inventory investment was needed to support a given level of sales. In the first case, where you are simply trying to avoid using a sudden spike or drop in the month-end inventory number, the average inventory calculation is to add together the beginning and ending inventory balances for a single month, and divide by two. The formula is: (Beginning inventory + Ending inventory) / 2 In the second case, where you want to obtain an average inventory figure that is representative of the period covered by year-to-date sales, add together the ending inventory balances for all of the months included in the year-to-date, and divide by the number of months in the year-to-date. For example, if it is now March 31 and you want to determine the average inventory to match against sales for the January through March period, then the calculation could be:

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January ending inventory February ending inventory March ending inventory Total

$185,000 $213,000 $142,000 $540,000

Average inventory = Total / 3 $180,000

Days of Inventory A variation on the average inventory concept is to calculate the exact number of days of inventory on hand, based on the amount of time it has historically taken to sell the inventory. This calculation is: 365 / (Annualized cost of goods sold / Inventory) Thus, if a company has annualized cost of goods sold of $1,000,000 and an ending inventory balance of $200,000, its days of inventory on hand is calculated as: 365 / ($1,000,000 / $200,000) = 73 Days of inventory Average Inventory Problems The following are all problems with the average inventory calculation:
1.

Month-end basis. The calculation is based on the month-end inventory balance, which may not be representative of the average inventory balance on a daily basis. For example, a company may traditionally have a huge sales push at the end of each month in order to meet its sales forecasts, which may artificially drop month-end inventory levels to well below their usual daily amounts. Seasonal sales. If you are using an inventory average that is based on the month-end balances for the yearto-date, results can be skewed if the companys sales are seasonal. This can cause abnormally low inventory balances at the end of the main selling season, as well as a major ramp-up in inventory balances just before the start of the main selling season. Estimated balance. Sometimes the month-end inventory balance is estimated, rather than being based on a physical inventory count. This means that a portion of the averaging calculation may itself be based on an estimate, which in turn makes the average inventory amount less valid.

2.

3.

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Inventory system
Inventory records relating to quantity and value can be maintained according to any of the following systems: 1. Periodic Inventory System 2. Perpetual Inventory System -Periodic Inventory System Periodic Inventory System Periodic Inventory System is a method of ascertaining inventory by taking an actual physical count (or measure or weight) of all the inventory items on hand at a particular date on which information about inventory is required. The cost of goods sold is calculated as a residual figure. In the course of operations, there may be theft pilferage. As cost of goods sold is calculated as a residual figure, it includes lost goods also. Cost of Goods Sold is calculated as under: Cost of Goods Sold = Opening Inventory + Purchases Closing Inventory -Perpetual Inventory System Perpetual Inventory System Perpetual Inventory System is a method of recording inventory balances after each receipt and issue. In order to ensure accuracy of perpetual inventory records, physical stocks should be checked and compared with recorded balances. The discrepancies, if any, should be investigated and adjusted in the accounts, properly. The closing inventory is calculated as a residual figure (which includes lost goods also) as under: Closing Inventory = Opening Inventory + Purchases Cost of Goods Sold Characteristics of Perpetual Inventory: The two main characteristics of perpetual inventory system are: 1. In perpetual inventory system, stores balances are recorded after each receipt and issue. Stores balances are always updated in the Bin Card. 2. This facilitates regular checking of stock verification, physically, which obviates the stopping of the work for stock taking. There will not be stoppage of production, in the case of continuous physical stock verification. In perpetual inventory, the experienced and dedicated staff, throughout the year, does stock-taking, continuously. All the items of stock are covered in a phased manner. The greatest advantage is this process does not disturb the business operations. Method of perpetual inventory: This continuous physical verification of stock is an essential feature of the perpetual inventory system. Certain number of items should be counted, weighted or measured, daily, and compared with the Bin Card balances. For example, an organization is possessing 30,000 items of stores. In a year of 300 working days, 100 items are verified physically, once in a year and compared with the Bin Card
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balances. The programme for physical stock verification covers counting, weighing or measuring daily so that all 30,000 items are verified, physically. The stock verifiers take up the different sections of the store, in rotation. All the items should be completely verified in a year so each item is covered once in a year under the physical stock verification programme and the results of stock verification should be recorded, suitably. Advantage of the Perpetual Inventory System 1. A detailed and reliable check on the materials in the stores is obtained. 2. It is not necessary to stop production. 3. No stock-taking at the year end. 4. Periodical and annual accounts can be prepared, easily, as per the balances in the stores ledger. 5. Experienced men can be employed to check the Stores at regular intervals. 6. Discrepancies are, readily, discovered and corrected. 7. Staff will be more vigilant and the system serves as a deterrent to dishonesty. 8. Facilitates fixation of the maximum and minimum levels and comparison with the actual physical balances. 9. The storekeepers duty, attending to replenishments, is facilitated. 10. The disadvantages of excessive stocks are avoided so capital investment in stocks is kept under control. 11. Correct stock figures are, readily, available for insurance purposes. 12. It reveals the existence of slow-moving, non-moving and obsolete stores etc. 13. A system of internal check would be readily available because the bin cards and stores ledger are crosschecked, periodically. Perpetual Inventory is Better than Periodic Inventory Periodic inventory is done, normally, at the end of the year, closing business operations, at least for a few days. In perpetual inventory, the experienced and dedicated staff does stock-taking throughout the year. All the items of stock are covered in a phased manner. The greatest advantage with perpetual inventory is this process of stock taking does not disturb the business operations as it is done throughout the year, continuously, in a planned manner, throughout the year. Method of Pricing issues and system of inventory influence cost of production and valuation of closing stock. In consequence, profitability of the firm depends upon the method of issues as well as system of inventory.

Effect of errors in Inventory valuation

An incorrect inventory balance causes an error in the calculation of cost of goods sold and, therefore, an error in the calculation of gross profit and net income. Left unchanged, the error has the opposite effect on cost of goods sold, gross profit, and net income in the following accounting period because the first accounting periods ending inventory is the second period's beginning inventory. The total cost of goods sold, gross profit, and net income for the two periods will be correct, but the allocation of these amounts between periods will be incorrect. Since financial statement users depend upon accurate statements, care must be taken to ensure that the
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inventory balance at the end of each accounting period is correct. The chart below identifies the effect that an incorrect inventory balance has on the income statement.

Impact of Error on Error in Inventory Ending Inventory Understated Overstated Overstated Understated Understated Understated Overstated Overstated Cost of Goods Sold Gross Profit Net Income

Beginning Inventory Understated Overstated Understated Overstated Overstated Overstated

Understated Understated

Balance sheet effects. An incorrect inventory balance causes the reported value of assets and owner's equity on the balance sheet to be wrong. This error does not affect the balance sheet in the following accounting period, assuming the company accurately determines the inventory balance for that period.

Impact of Error on Error in Inventory Assets = Understated Overstated Liabilities + Owner's Equity Understated Overstated

Understated No Effect Overstated No Effect

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Inventory management system

1. Economic Order Quantity Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by Ford W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis. EOQ applies only when demand for a product is constant over the year and each new order is delivered in full when inventory reaches zero. There is a fixed cost for each order placed, regardless of the number of units ordered. There is also a cost for each unit held in storage, commonly known as holding cost, sometimes expressed as a percentage of the purchase cost of the item. We want to determine the optimal number of units to order so that we minimize the total cost associated with the purchase, delivery and storage of the product. The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order and the storage cost for each item per year. Note that the number of times an order is placed will also affect the total cost, though this number can be determined from the other parameters. Underlying assumptions 1. 2. 3. 4. 5. 6. The ordering cost is constant. The rate of demand is known, and spread evenly throughout the year. The lead time is fixed. The purchase price of the item is constant i.e. no discount is available The replenishment is made instantaneously, the whole batch is delivered at once. Only one product is involved.

EOQ is the quantity to order, so that ordering cost + holding cost finds its minimum. (A common misunderstanding is that the formula tries to find when these are equal.) 2. ABC analysis The ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control. Policies based on ABC analysis:

A ITEMS: very tight control and accurate records. B ITEMS: less tightly controlled and good records. C ITEMS: simplest controls possible and minimal records.

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The ABC analysis provides a mechanism for identifying items that will have a significant impact on overall inventory cost, while also providing a mechanism for identifying different categories of stock that will require different management and controls. The ABC analysis suggests that inventories of an organization are not of equal value. Thus, the inventory is grouped into three categories (A, B, and C) in order of their estimated importance. 'A' items are very important for an organization. Because of the high value of these A items, frequent value analysis is required. In addition to that, an organization needs to choose an appropriate order pattern (e.g. Justin- time) to avoid excess capacity. 'B' items are important, but of course less important than A items and more important than C items. Therefore B items are intergroup items. 'C' items are marginally important. There is no fixed threshold for each class, different proportion can be applied based on objective and criteria. ABC Analysis is similar to the Pareto principle in that the 'A' items will typically account for a large proportion of the overall value but a small percentage of number of items. Example of ABC class are

A items 20% of the items accounts for 70% of the annual consumption value of the items. B items - 30% of the items accounts for 25% of the annual consumption value of the items. C items - 50% of the items accounts for 5% of the annual consumption value of the items.

Another recommended breakdown of ABC classes: 1. "A" approximately 10% of items or 66.6% of value 2. "B" approximately 20% of items or 23.3% of value 3. "C" approximately 70% of items or 10.1% of value

Summary
Companies may have inventories held in the form of raw materials, work-in-progress, finished goods, products bought for resale, and service items. At the end of the financial year, the company must make a physical inventory count and value its inventory for use in the financial statements in the calculation of profit, and for the balance sheet. In order to be able to calculate accurately the price at which inventories of materials are issued and to ascertain a valuation of inventory, a stores ledger record or inventory card is used. The overriding principle of inventory valuation set out in IAS 2, Inventories is that inventories are to be valued at the lower of cost and net realizable value.
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IAS 2, Inventories , allows two methods to be used to value inventory: FIFO (first in, first out) AVCO (average cost) Having chosen an inventory valuation method, a company should apply it consistently. The use of either FIFO or AVCO may result in a different value for closing inventory and, hence, a different reported profit for a particular time period. However, over the life of a business, total profit is the same, whichever method is chosen. IAS 2, Inventories , requires that, in calculating the lower of cost and net realizable value, note should be taken of separate items of inventory, or groups of similar items An inventory count is carried out regularly to check that the quantity of inventory held is the same as that recorded in the inventory records. An inventory count is carried out on either a periodic basis or continuously. Inventory reconciliation is the process of comparing the inventory count and the inventory record. Small shortfalls in physical inventory may be authorized for write-off by the companys managers or auditors; larger discrepancies will need to be investigated to establish their cause.

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