Accounting for Materials

Transcription

1 Accounting for Materials The correct valuation of inventory is of the utmost importance because it has a direct impact on profit. You may be aware from your Financial Accounting Studies that under IAS 2 inventories are valued at the lower of cost and net realisable value. IAS2 further explains that the only valuation method which is allowable is FIFO. Thus, when preparing Financial Accounting information we have very limited choice in how to value inventory. However in Management Accounting as we are under no obligation to follow accounting standards or present information in any particular way, we have a choice of inventory valuation methods. We can use: - FIFO (First in, First Out) - LIFO (Last in, First Out) - AVCO (Cumulative Weighted Average Cost) FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold first but do not necessarily mean that the exact oldest physical object has been tracked and sold. EXAMPLE: Terry Ltd is a furniture shop. July was their first month of trading. During July they purchased 10 tables and sold 6 tables details of which are as follows: July 1 Purchased 5 tables at 50 each July 5 Sold 2 tables July 10 Sold 1 table July 15 Purchased 5 tables at 70 each July 25 Sold 3 tables In total 10 tables have been purchased and 6 sold. The question is what do we value the remaining 4 tables at? Using FIFO we match the values of the FIRST sales to the FIRST purchases. So the first 3 tables sold will come from the first 5 purchased, and of the next 3 sold 2 will come from the first 5 purchased and 1 will come from the second five purchased. Crucially this means the remaining 4 tables in inventory are valued at the purchase price of the second batch of 5 tables purchased i.e. 70 each. So closing inventory is therefore 4 x 70 = 280. LIFO stands for last-in, first-out, meaning that the most recently purchased items are recorded as sold first. Since the 1970s, some U.S. companies shifted towards the use of LIFO, which reduces their income taxes in times of inflation, but with International Financial Reporting Standards banning the use of LIFO, more companies have gone back to FIFO. LIFO is most commonly used in the US. Using the above example of Terry Ltd our closing inventory figure will be different under LIFO. The first 3 tables sold will still come from the first 5 purchased, however the next 3 sold will come from the second batch of tables purchased. This will mean our value of closing inventory will

2 include 2 tables from the first batch (2x 50) and 2 tables from the second batch (2x 70) giving us a total closing inventory of 240. As we can see the value of inventory using LIFO will be based on outdated prices. This is the reason the LIFO method is not allowed for under IAS 2. One of the reasons that can easily be understood is that LIFO cause reduction in tax burden under inflationary economies i.e. in the times of rising prices. This happens because LIFO assumes that inventory which is bought latest will be sent to production hall to be consumed in the production process and thus higher value inventory will be included in cost of sales figure which will result in larger cost and ultimately lesser profits and thus lesser tax. So, many argue that LIFO is one of the tools to save tax expenses. However, the major reason is not the impact on tax. The main reason for excluding the LIFO is because IFRSs shifted its focus on balance sheet instead of income statement which is also known as balance sheet approach. The impact of this turn in focus from income statement to statement of financial position (SoFP) requires that the figures in the SoFP should be according to present market conditions i.e. it should provide the most relevant information with respect to time and if the statement of financial position items are measured according to up to date information only then financial position can be ascertained reliably. Now under LIFO as Last-in inventory is expensed out as cost of sales and old inventory is kept in the store therefore, the figure that will be reported in the SoFP, which will be according to the inventory in store, might be too old to be relevant for the users of financial statements. That was the main reason for abandoning the LIFO inventory valuation method as it was causing outdated information in the statement of financial position. AVCO is the average cost method. This method values inventory at the weighted average cost of all purchases. Average cost is calculated each time inventory is issued. In the above example, the first 3 tables sold will still come from the first 5 purchased, however the next 3 sold will be based on the weighted average cost of the inventory in stores at that time. So when we go to sell the 2 nd 3 tables, we have in store 2 tables which cost 50 each and 5 tables which cost 70 each giving us a total of 7 tables which cost 450. The average cost of each table is therefore 450/7 = We will sell the three tables at this cost 3 x = This means our closing inventory is = Alternatively we will have 4 tables remaining at an average cost of 64.29, so 4 x = This method is only practicable where the number of inventory items is very small and distinguishable such as in the property business.

3 Advantages and disadvantages of each method FIFO Advantages: It is a logical pricing method which probably represents what is physically happening: in practice the oldest inventory is likely to be used first. It is easy to understand and explain to managers The inventory valuation can be near to a valuation based on a replacement cost FIFO disadvantages: FIFO can be cumbersome to operate because of the need to identify each batch of material separately Managers may find it difficult to compare costs and make decisions when they are charged with varying prices for the same materials In a period of high inflation, inventory issue prices will lag behind current market value LIFO advantages: Inventories are issued at a price that is close to current market value Managers are continually aware of recent costs when making decisions, because the costs being charged to their department or products will be current costs. LIFO disadvantages: The method can be cumbersome to operate because it sometimes results in several batches being only part-used in the inventory records before another batch is received LIFO is the opposite to what is physically happening and can therefore be difficult to explain to managers As with FIFO, decision making can be difficult because of the variations in pricing. AVCO advantages: Fluctuations in prices are smoothed out, making it easier to use the data for decision making It is easier to administer than FIFO and LIFO, because there is no need to identify each batch separately AVCO disadvantages: The resulting issue price is rarely an actual price that has been paid, and can run to several decimal places Prices tend to lag a little behind current market values when there is gradual inflation The management of inventory Inventory costs can be conveniently analysed into four groups: 1.) Holding Costs comprise the cost of capital tied up, warehousing and handling costs, deterioration, obsolescence, insurance and pilferage. 2.) Procuring costs consist of ordering costs for goods purchased externally such as clerical costs, telephone charges and delivery costs. 3.) Shortage costs including the loss of contribution which could have been earned from the sale and the extra cost of having to buy emergency stock at a high price 4.) The cost of purchasing the inventory itself.

4 Some businesses attempt to control inventory on a scientific basis by balancing the costs of inventory shortages against those of inventory holding. The scientific control of inventory can be analysed into three parts: 1. The economic order quantity (EOQ) model can be used to decide the optimum order size for inventory which will minimise the costs of ordering stocks plus and the cost of holding inventory 2. If discounts are available for bulk purchases, it may be cheaper to buy inventory in large order sizes so as to obtain the discounts 3. The decision to hold buffer stock in order to reduce or eliminate the risk of running out of stock 4. The basic EOQ formula The economic order quantity is the optimal order quantity for an item of stock which will minimise costs. Let D = the usage in units for one year (demand) Co = the cost of ordering Ch = the annual holding cost Q = the re-order quantity The order quantity which will minimise these costs is: Q = 2 xco x D Ch Example: The demand for a product is 40,000 units a year. It costs 20 to place an order and 40 cents to hold a unit for a year. Find the order size to minimise stock costs, the number of orders placed each year and the length of the stock cycle. Solution: Q = 2 x 20 x 40,000 = 2,000 units. This is the order size to minimise stock costs This means there will be 40,000 / 2,000 = 20 orders placed each year. So the stock cycle is 52/20 = once every 2.6 weeks Total costs will be: Cost of ordering = No of Orders x Cost of ordering = 20 x 20 = 400 Cost of holding = Re-order quantity x Cost of holding / 2 = 2,000 x 0.40 / 2 = = 800 total cost

5 Just in Time (JIT) Procurement: In recent years some companies have sought to reduce their inventories to as low a level as possible. This approach differs from other models such as EOQ model, which seek to minimise cost rather than inventory levels. Just in time procurement is a policy of obtaining goods from suppliers at the latest possible time i.e. exactly when they are needed and so avoiding any need to carry raw materials or stock. A JIT policy should also be aimed at improving production systems, eliminating waste and avoiding production bottlenecks. Introducing JIT might bring the following potential benefits: - Reduction in stock holding costs - Reduced manufacturing lead times - Improved labour productivity - Reduced scrap / rework cost - Price reductions on purchased materials - Reduction in the number of accounting transactions Reduced stock levels mean that a lower level of investment in working capital will be required.