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Inventory cost

Inventory cost includes the costs to order and hold inventory, as well as to administer the related
paperwork. This cost is examined by management as part of its evaluation of how much inventory
to keep on hand. This can result in changes in the order fulfillment rate for customers, as well as
variations in the production process flow.

Inventory costs can be classified as follows:

1. Ordering costs. These costs include the wages of the procurement department and related
payroll taxes and benefits, and possibly similar labor costs by the industrial engineering
staff, in case they must pre-qualify new suppliers to deliver parts to the company. These
costs are typically included in an overhead cost pool and allocated to the number of units
produced in each period.
2. Holding costs. These costs are related to the space required to hold inventory, the cost of
the money needed to acquire inventory, and the risk of loss through inventory
obsolescence. Most of these costs are also included in an overhead cost pool and allocated
to the number of units produced in each period. More specifically, holding costs include:
o Cost of space. Perhaps the largest inventory cost is related to the facility within
which it is housed, which includes warehouse depreciation, insurance, utilities,
maintenance, warehouse staff, storage racks, and materials handling equipment.
There may also be fire suppression systems and burglar alarms, as well as their
servicing costs.
o Cost of money. There is always an interest cost associated with the funds used to
pay for inventory. If a company has no debt, this cost represents the foregone
interest income associated with the allocated funds.
o Cost of obsolescence. Some inventory items may never be used or will be damaged
while in storage, and so must be disposed of at a reduced price, or at no price at all.
Depending on how perishable the inventory is, or the speed with which technology
changes impact inventory values, this can be a substantial cost.
3. Administrative costs. The accounting department pays the wages of a cost accounting staff,
which is responsible for compiling the costs of inventory and the cost of goods sold,
responding to other inventory analysis requests, and defending their results to the
company's internal and external auditors. The cost of cost accounting personnel is charged
to expense as incurred.

As the preceding list reveals, the cost of inventory is substantial. If not properly monitored and
adjusted, inventory costs can eat into profits and cash reserves.

Perpetual vs Periodic Inventory System


Perpetual inventory system and periodic inventory systems are the two systems of keeping
records of inventory.
In perpetual inventory system, merchandise inventory and cost of goods sold are updated
continuously on each sale and purchase transaction. Some other transactions may also require an
update to inventory account for example, sale/purchase return, purchase discounts etc. Purchases
are directly debited to inventory account whereas for each sale two journal entries are made: one
to record sale value of inventory and other to record cost of goods sold. Purchases account is not
used in perpetual inventory system.

In periodic inventory system, merchandise inventory and cost of goods sold are not updated
continuously. Instead purchases are recorded in Purchases account and each sale transaction is
recorded via a single journal entry. Thus cost of goods sold account does not exist during the
accounting period. It is determined at the end of accounting period via a closing entry.

Differences Between Perpetual and Periodic System

Following are the main differences between perpetual and periodic inventory systems:

 Inventory Account and Cost of Goods Sold Account are used in both systems but they are
updated continuously during the period in perpetual inventory system whereas in periodic
inventory system they are updated only at the end of the period.
 Purchases Account and Purchase Returns and Allowances Account are only used in periodic
inventory system and are updated continuously. In perpetual inventory system purchases are
directly debited to inventory account and purchase returns are directly credited to inventory
account.
 Sale Transaction is recorded via two journal entries in perpetual system. One of them records
the sale value of inventory whereas the other records cost of goods sold. In periodic inventory
system, only one entry is made.
 Closing Entries are only required in periodic inventory system to update inventory and cost of
goods sold. Perpetual inventory system does not require closing entries for inventory account.

The difference between the periodic and


perpetual inventory systems
August 02, 2017

The periodic and perpetual inventory systems are different methods used to track the quantity of
goods on hand. The more sophisticated of the two is the perpetual system, but it requires much
more record keeping to maintain. The periodic system relies upon an occasional physical count
of the inventory to determine the ending inventory balance and the cost of goods sold, while the
perpetual system keeps continual track of inventory balances. There are a number of other
differences between the two systems, which are as follows:

 Accounts. Under the perpetual system, there are continual updates to either the general ledger
or inventory journal as inventory-related transactions occur. Conversely, under a periodic
inventory system, there is no cost of goods sold account entry at all in an accounting period until
such time as there is a physical count, which is then used to derive the cost of goods sold.
 Computer systems. It is impossible to manually maintain the records for a perpetual inventory
system, since there may be thousands of transactions at the unit level in every accounting
period. Conversely, the simplicity of a periodic inventory system allows for the use of manual
record keeping for very small inventories.
 Cost of goods sold. Under the perpetual system, there are continual updates to the cost of
goods sold account as each sale is made. Conversely, under the periodic inventory system, the
cost of goods sold is calculated in a lump sum at the end of the reporting period, by adding total
purchases to the beginning inventory and subtracting ending inventory. In the latter case, this
means it can be difficult to obtain a precise cost of goods sold figure prior to the end of the
reporting period.
 Cycle counting. It is impossible to use cycle counting under a periodic inventory system, since
there is no way to obtain accurate inventory counts in real time (which are used as a baseline for
cycle counts).
 Purchases. Under the perpetual system, inventory purchases are recorded in either the raw
materials inventory account or merchandise account (depending on the nature of the purchase),
while there is also a unit-count entry into the individual record that is kept for each inventory
item. Conversely, under a periodic inventory system, all purchases are recorded into a purchases
asset account, and there are no individual inventory records to which any unit-count
information could be added.
 Transaction investigations. It is nearly impossible to track through the accounting records under
a periodic inventory system to determine why an inventory-related error of any kind occurred,
since the information is aggregated at a very high level. Conversely, such investigations are
much easier in a perpetual inventory system, where all transactions are available in detail at the
individual unit level.

This list makes it clear that the perpetual inventory system is vastly superior to the periodic
inventory system. The primary case where a periodic system might make sense is when the
amount of inventory is very small, and where you can visually review it without any particular
need for more detailed inventory records. The periodic system can also work well when the
warehouse staff is poorly trained in the uses of a perpetual inventory system, since they might
inadvertently record inventory transactions incorrectly in a perpetual system.

What do you mean by Slip system of posting


and what are its advantages and dis-
advantages ?
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In this system, posting is made from slips prepared inside the organisation itself or from slips
filled in by its customers. So entries are not made in the books of original entry or subsidiary
books, but posting of entries is done from slips. In a banking company, the main slips are pay-in-
slips, withdrawal slips and cheques and all these slips are filled in by clients of the bank. These
slips serve the basis of entry in the ledgers and control accounts in the General Ledger are
prepared on the basis of analysis of these slips. The main reasons for the adoption of the slip
system of posting by the bank are the following

(1) The bank must have customer’s account up-to-date for a customer may present a cheque any
time during hours meant for the public. Slip system helps in keeping the accounts up-to-date.

(2) The number of transactions in a bank is very large. The adoption of slip system can suitably
distribute the work of posting among many persons.

(3) It ensures smooth flow of accounting work.

The main advantages of the slip system are:

(1) The bank saves a lot of clerical labour as most of the slips are filled in by its customers.

(2) Subsidiary books are avoided as posting is done from slips.

(3) Entries can be recorded with minimum delay as slips can easily pass from hand to hand
among clerks concerned.

The disadvantages of the slip system are :

(1) Slips may be lost, destroyed or misappropriated as these are loose.

ADVERTISEMENTS:

(2) Books cannot be verified if subsidiary books are not kept.

The current ratio is a financial ratio that express the liquidity of a company and its ability to pay short-term
liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The standard
current ratio is 2:1.

The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets to cover its
immediate liabilities. This metric is more robust than the current ratio, also known as the working capital
ratio, since it ignores illiquid assets such as inventory. The standard acid test ratio is 2:1
The debt-to-equity ratio shows the proportion of equity and debt a firm is using to finance its assets, and
the extent to which shareholder's equity can fulfill obligations to creditors in the event of a business
decline.

The times interest earned ratio, sometimes called the interest coverage ratio, measures the proportionate
amount of income that can be used to cover interest expenses in the future.

However, in case of this problem, Company A should be preferred for granting loan as the
company maintains more strong position in current ratio and acid test ratio than company B.
Moreover, the company has lower debt equity ratio than Company B. Furthuremore, interest
earned ratio of company A is higher than company B which implies more strength of Company A
to repay its loan.

b) Both of the company maintains standard in terms of current ratio but in case of Acid test ratio
both of the company has below the standard ratio though the company A has higher Acid Test
Ratio than Company B. Besides, higher debt-equity ration gives the company to increase its
income. In this case, company B has greater opportunity than company A. In addition, Interest
earned ratio of company a is more satisfactory than company B. If the loan officer wants give loan
to both A & B Company, in case of company B, the officer needs to be more careful as the company
b has lower acid test ratio and interest earned ration than company a. so, the officer would sanction
the loan by considering above things.