Managing Inventory in Accounting Assignments: Valuation Methods and Control
Inventory is one of the most important assets for a business, so managing it is an important part of accounting. Inventory valuation and control are important for making sure that the business runs smoothly and that business decisions are well-informed. This blog will talk about the different ways to value inventory, like the first-in, first-out (FIFO), last-in, first-out (LIFO), and weighted average cost methods, as well as different ways to control inventory, like the just-in-time (JIT) and economic order quantity (EOQ) methods (EOQ).
Inventory Valuation Methods
Inventory valuation is an important part of accounting because it helps figure out the cost of goods sold, which in turn affects how profitable the company is. The way a business chooses to value its inventory can have a big effect on its financial statements and tax obligations.
1. First-In, First-Out (FIFO) Method
This method is based on the idea that the first things bought are also the first things sold. This method is good for stores that sell goods that go bad quickly because it makes sure that the older items are sold first. In times of inflation, the FIFO method makes more money because the older, cheaper inventory is used first, which lowers the cost of goods sold.
Advantages of FIFO Inventory Valuation Method
Better Matching of Revenue and Expenses
The FIFO method assumes that the oldest items in stock are sold first, so the cost of goods sold is based on the cost of the oldest items in stock. This method better matches the money made from selling goods with the costs of making them, which leads to more accurate financial statements.
Suitable for Perishable Goods
The FIFO method is great for businesses that sell goods that go bad or expire quickly because it makes sure that the oldest items in stock are sold first.
Helps in Tax Planning
In times of inflation, the FIFO method makes more money because the older, cheaper items are sold first. By lowering their taxable income, this method can help businesses lower their tax bills.
Disadvantages of FIFO Inventory Valuation Method
Increased Holding Costs
The FIFO method assumes that the oldest items in stock are the ones that are kept, which means that the costs of holding stock go up as the stock gets older. This method can cause storage and insurance costs to go up.
Unsuitable for Non-Perishable Goods
Businesses that sell non-perishable goods shouldn't use the FIFO method because it can lead to a difference between the cost of goods sold and the current market value of the inventory.
Higher Tax Liability
In times of deflation, the FIFO method leads to a higher cost of goods sold because the older, cheaper items in the inventory are sold first. This leads to a higher taxable income and more taxes owed.
2. Last-in, First-out Method (LIFO)
This method is based on the idea that the last things bought will be the first things sold. LIFO works well for businesses that sell non-perishable goods because it makes sure that the newest stock is sold first. In times of inflation, the LIFO method makes less money because the newest, most expensive items are used first, which raises the cost of goods sold.
Advantages of LIFO method
Suitable for Non-Perishable Goods
The LIFO method is good for businesses that sell non-perishable goods because it assumes that the newest items in stock are sold first, which is closer to how much the stock is worth right now.
Lower Tax Liability in Inflationary Times
In times of inflation, the LIFO method leads to a lower taxable income because the most recent and most expensive items are sold first. This lowers the cost of goods sold and lowers the amount of tax that needs to be paid.
Reduced Holding Costs
The LIFO method assumes that the newest items in stock are sold first. This means that holding costs are lower because the stock is less likely to get old or become useless.
Disadvantages of LIFO method
Could cause lower gross margins.
The LIFO method can cause the gross margin to be lower because the cost of goods sold is based on the higher, more recent costs of inventory. This method can make it harder to make money, especially when costs are going up.
Unsuitable for Perishable Goods
The LIFO method is not good for businesses that sell goods that go bad quickly because it assumes that the newest items are sold first, which makes it more likely that goods will go bad or expire.
Higher Tax Liability in Deflationary Times
In times of deflation, the LIFO method leads to a higher taxable income because the newest and most expensive items are sold first. This raises the cost of goods sold and the amount of tax that needs to be paid.
3. Weighted Average Cost Method
This method figures out the average cost of all the items bought during a certain time period. To figure out the cost of goods sold, multiply the average cost by the number of units sold. This method is good for businesses that sell similar goods at different prices, because it gives an average cost for all inventory items.
Advantages of Weighted Average Cost Method
• It's easy to calculate and understand. The weighted average cost method is a popular way for small businesses to figure out how much their inventory is worth.
• Evens out price changes. The weighted average cost method figures out the average cost of all inventory items. This makes the cost of goods sold more stable and less affected by changes in the prices of inventory items.
• Good for Businesses That Sell Similar Items at Different Prices: The weighted average cost method is good for businesses that sell similar items at different prices. It gives a good cost estimate for each item.
Disadvantages of Weighted Average Cost Method
• May Not Show Current Market Value: The weighted average cost method calculates the average cost of all inventory items, which may not accurately show the current market value of the inventory. This method can cause inventory to be overvalued or undervalued.
• May Not Show the Real Cost of Goods Sold: The weighted average cost method assumes that all inventory items are equally important and gives each one an average cost. This may not show the real cost of goods sold, though.
• Not Good for unique Items: The weighted average cost method is not good for businesses that sell unique or one-of-a-kind inventory items because it may not give a true picture of how much each item costs.
Inventory Control Strategies
Inventory control strategies are the ways and processes that businesses use to keep the right amount of inventory on hand while keeping costs as low as possible. Effective inventory control strategies can help businesses make more money, reduce the costs of keeping inventory on hand, and make customers happier.
Businesses can use different ways to keep track of their stock, such as:
1. Just-In-Time Method (JIT)
The Just-In-Time (JIT) method is a way to make and deliver products only when they are needed. This cuts down on the amount of inventory and the costs that come with it. Unlike the Economic Order Quantity (EOQ) formula, the JIT method does not have a specific mathematical formula for figuring out the best level of inventory.
Instead, the JIT method is based on a set of rules and practices that focus on continuous improvement, reducing waste, and making the process run as smoothly as possible. Some of the most important ideas behind the JIT method are:
• Continuous Improvement: The JIT method focuses on improving production processes all the time to cut down on waste, make them better, and make them run more efficiently.
• Pull System: The JIT method uses a pull system, in which items are only made and sent out when a customer asks for them.
• Kanban System: The JIT method uses a Kanban system, which is a visual signaling system that helps manage inventory levels and production flow.
• Flexible Manufacturing: The JIT method depends on manufacturing processes that can quickly adjust to changes in demand and customer needs.
The JIT method doesn't have a set formula, but businesses can use tools and techniques like value stream mapping, total quality management, and lean manufacturing to put its ideas and practices into action. By using these tools and methods, businesses can cut down on their inventory, improve their efficiency, and make their customers happier.
Economic Order Quantity (EOQ) Method
The Economic Order Quantity (EOQ) formula is a math model that is used to figure out how much a business should order at a given time to keep inventory costs and ordering costs to a minimum. The formula takes into account how much it costs to hold inventory, how much it costs to order inventory, and how much demand there is for the item.
The basic EOQ formula is:
EOQ = sqrt((2 x D x O) / H)
EOQ = Economic Order Quantity
D = Annual Demand for the inventory item
O = Ordering Cost per order
H = Holding Cost per unit per year
By putting in the values for D, O, and H, a business can figure out the EOQ that will help them keep their inventory and ordering costs to a minimum. The result is the optimal number of orders that should be made to keep the costs of holding inventory and placing orders in balance.
It's important to keep in mind that the EOQ formula assumes that demand and lead times will stay the same and that there won't be any discounts for buying in bulk. But the formula can be changed to take into account changes in demand and lead times as well as discounts for bigger orders.
Economic Order Quantity (EOQ) Method Pros
• Lowers the cost of ordering: The EOQ method helps businesses lower the cost of ordering by figuring out the best order size to minimize the number of orders and the administrative costs that come with them.
• Lowers the cost of keeping inventory on hand. The EOQ method helps businesses keep the right amount of inventory on hand by ordering items only when they are needed. This lowers inventory holding costs and other costs like storage, handling, and insurance.
• Makes inventory management more efficient: The EOQ method makes inventory management more efficient by giving a simple and effective way to keep track of inventory levels. This cuts down on the time and resources needed to track and manage inventory.
The Economic Order Quantity (EOQ) method has some drawbacks.
• Assumes Demand and Lead Times Will Stay the Same Over Time: The EOQ method assumes that demand and lead times will stay the same over time, which may not be true in the real world. Changes in demand or lead times can cause either a lack of stock or too much stock.
• May Not Take Seasonal Demand Into Account: The EOQ method may not take seasonal demand patterns into account, which can lead to less-than-optimal levels of inventory and higher costs for holding them.
• Needs Accurate Data: The EOQ method needs accurate and up-to-date data on inventory levels, demand, and lead times. If there are mistakes or differences in the data, the inventory levels might not be right and costs might go up.
Inventory Control Techniques
Businesses need inventory control techniques to keep track of their stock levels and make sure they have the right amount of stock to meet customer demand. Some common inventory control techniques include:
ABC analysis is a common method for managing inventory that helps businesses decide how to control their stock first. It sorts inventory items into three groups based on how important they are. The three groups are:
• A Items: These are the most important and high-value items in the stock. They usually make up 10–20% of the stock but are worth 70–80% of the stock's total value.
• B Items: These are fairly important inventory items that usually make up 20–30% of the total inventory and 10–20% of the total value of the inventory.
• Items C: These are the least important and least valuable items in the stock. They usually make up 50–60% of the stock but only 5–10% of the stock's value.
By putting inventory items into these groups, businesses can focus their inventory control efforts on the A items, which have the biggest effect on their operations and profits. This lets them get the most out of their efforts to manage their inventory and reduces the risk of stockouts and having too much inventory.
ABC analysis can be done with a number of different metrics, such as annual sales, unit sales, and the value of the inventory. The key is to choose a metric that shows how important each item is to the business and to set the right limits for each category.
ABC analysis is a good way to keep track of inventory, but it should be used with other techniques and tools to make sure that inventory management is done well. For example, businesses can use reorder point calculations and economic order quantity (EOQ) calculations to figure out how much of each type of inventory they should have on hand. By using all of these methods together, businesses can get the right amount of inventory, cut costs, and make customers happier.
Cycle counting is a way to keep track of inventory that involves counting a small part of the inventory regularly instead of all of it at once. This lets businesses keep accurate inventory records without having to do a full physical inventory count, which can be a hassle and cost a lot of money.
Counting cycles can be done in different ways, such as:
• Random Sampling: This means picking a random number of inventory items to count, usually based on a percentage or dollar amount that has already been set.
• ABC Analysis: This means that the high-value A items are counted more often than the B and C items.
• Location-based: This involves counting specific inventory locations on a rotating basis, like counting one aisle or shelf each day or week.
The success of a business depends on how well it can value and control its inventory. The type of inventory a business sells and the state of the economy determine which method is best for figuring out the value of its stock. Inventory control methods like Just-in-Time (JIT) and Economic Order Quantity (EOQ) help businesses get the most out of their stock and keep costs for holding and ordering stock to a minimum. Techniques for inventory control, like ABC analysis and cycle counting, help businesses find discrepancies in their inventory and decide how to manage it. Businesses can make better decisions and improve their bottom line if they have good ways to value and control their inventory.