Page 1: Introduction to Inventory Management

École de gestion TELFER

• Affiliation: School of Management

• Focus: Financial Accounting, Leadership

• Chapter 6: Inventory

• Author: Shujun Ding, Ph.D.

Page 2: Study Objectives

Objectives of Chapter 6

• Determine inventory quantities.

• Understand cost determination methods:

  • Specific identification

  • FIFO (First-In, First-Out)

  • Average cost

• Explain financial statement effects of inventory cost methods.

• Present and analyze inventory effectively.

• Apply inventory cost formulas for FIFO and average in periodic inventory systems.

Page 3: Determining Inventory Quantities

Importance of Physical Inventory

• All companies must perform a physical inventory count at the end of the period, whether utilizing a perpetual or periodic system.

• Reasons for Physical Count:

  • Validate perpetual inventory records

  • Assess inventory losses due to shrinkage or theft

Page 4: Taking Inventory

Ensuring Accurate Inventory Count

• Companies should implement a solid internal control system for inventory counting:

  • Count personnel should not manage custody or records.

  • Validator ensures item legitimacy.

  • Second independent count by another employee/auditor.

  • Utilize pre-numbered tags for tracking.

Page 5: Ownership of Goods

Goods and Ownership Considerations

• Key Considerations: Goods in transit complicate ownership determination:

  • Establish who has legal title to in-transit goods.

  • Include items in inventory only if legal title is with the company.

Page 6: Freight/Shipping Concepts

Freight Concepts (from Chapter 5)

• Differentiate ownership based on:

  • FOB Shipping Point:

    • Ownership transfers at sender's shipping location.

  • FOB Destination:

    • Ownership transfers when received by the buyer.

• Ownership of consigned goods stays with the consignor, not the consignee.

• Goods taken “on approval” by customers remain owned by the company.

Page 7: Inventory Cost Determination Methods

Methods of Cost Determination

• After counting inventory quantities, unit costs need to be applied to total inventory cost.

• Challenges:

  • Units purchased at varying prices.

  • Determine appropriate costs to apply.

Page 8: Specific Identification Method

Specific Identification

• Tracks the actual physical flow of goods, applicable solely in a perpetual system.

• Usable only when:

  • Actual costs for each item can be identified.

  • Goods can be easily distinguished.

  • Items produced for specific projects are identified.

Page 9: Cost Formulas

Inventory Cost Calculation Standards

• Cost formulas represent assumptions about the flow of costs that may differ from the actual movement of goods:

  • FIFO (First-In, First-Out): First purchased items are first sold.

  • Average Method: Cost represented by a moving average of items purchased.

Page 10: FIFO Method

FIFO (First-In, First-Out) Application

• Records merchandise inventory at the current cost in the current assets section of the financial statement.

• Cost of goods sold (COGS) is logged as an expense at the oldest inventory cost.

Page 11: FIFO Consistency

Consistency in FIFO Method

• Ending inventory and COGS are consistent under FIFO, regardless of whether a periodic or perpetual inventory system is in place.

Page 12: FIFO Inventory Costing Example

Perpetual System FIFO Example

• Records purchases, COGS, and balance for select transactions:

  • Date: Jan 1, Apr 15, May 1, Aug 24, etc.

  • Details about units, costs, and totals are tabulated.

Page 13: Average Cost Method

Average Method

• Suitable when measuring the physical inventory flow is challenging.

• Average recalculated after each purchase under a perpetual inventory system.

• Used to note COGS and ending inventory.

Page 14: Average Cost Calculations

Average Cost Calculations Example

• Detailed calculations of average costs across transactions, illustrating how averages update after sales and purchases.

Page 15: Selecting Cost Determination Method

Choosing the Right Method

• Select a method that:

  • Most accurately reflects physical flow of goods.

  • Reports ending inventory at contemporary costs.

  • Consistently applied across similar inventory types.

Page 16: Advantages of Cost Determination Methods

Cost Determination Advantages

• Specific Identification: Matches costs with revenues closely; tracks physical flow.

• FIFO: Ending inventory reflects recent costs, aligning with the physical flow in retail.

• Average: Smoothens price fluctuations; assigns all units an identical average cost.

Page 17: Financial Statement Effects Summary

Financial Statements Overview (during rising prices)

• Effects on the income statement:

  • Specific Identification: COGS variable, gross profit variable.

  • FIFO: Generally leads to lowest COGS, highest gross profit.

  • Average: Balances between the two extremes.

• On the statement of financial position, effects on cash, ending inventory, and retained earnings vary across methods.

Page 18: Valuation Rules

Inventory Valuation Rules

• If net realizable value is lower than cost, a write-down occurs:

  • Lower of Cost and Net Realizable Value (LCNRV) rule applies.

• Net realizable value calculated as sales price minus readiness costs.

Page 19: Application of LCNRV Rule

LCNRV Application

• Apply write-down rules to individual inventory items.

• Credit inventory, debit COGS for amount of the write-down.

• Reusability of write-downs if previous conditions change is allowed.

Page 20: Reporting Inventory

Reporting Standards

• No major variations between IFRS and ASPE standards:

  • Present at the lower of cost or NRV in financial statements.

  • Include detailed notes on inventory amounts, COGS, cost determination methods, and write-downs.

Page 21: Managing Inventory

Inventory Management Ratios

• To optimize inventory, utilize:

  • Inventory Turnover Ratio: Number of times inventory sold in a given period.

  • Days in Inventory Ratio: Provides average days inventory held.

Page 22: Ratios Summary

Summary of Inventory Ratios

• Higher inventory turnover and lower days in inventory generally indicate better inventory management:

  • Inventory Turnover Calculation: COGS/Average inventory.

  • Days in Inventory Calculation: 365 days/Inventory turnover.

Page 23: Inventory Cost Formulas in Periodic Systems

Periodic Inventory Systems

• Cost determination using FIFO and average method also applicable in periodic systems.

• Allocation made at period end.

Page 24: Periodic FIFO Illustration

Example of Periodic FIFO Accounting

• Presents a cost of goods available for sale and how to calculate COGS step by step under FIFO.

Page 25: Periodic Average Illustration

Example of Periodic Average Accounting

• Displays a similar process for calculating ending inventory and COGS using a moving average approach.

Page 26: Illustrative Methods

Inventory Costing Methods Illustration

• Further specific identification methods review, emphasizing individual item tracking and unique product characteristics.

Page 27: Specific Identification in Practice

Specific Identification Example

• A fine art gallery's transaction example shows the individual identification and journalization for a high-value item sale.

Page 28: Example of Specific Identification

Sales Transaction Demonstration

• Demonstrates the journal entries required for selling a specific painting from inventory, highlighting cost and sales transactions.

Page 29: Perpetual FIFO Calculation

FIFO Explanation and Application

• A comprehensive example where items are updated post each sale/purchase, leading to precise calculations for ending inventory and COGS.

Page 30: Example of Sales and Inventory Updates

Detailed Inventory and COGS Example

• Illustrates tracking COGS and remaining inventory items reflecting the calculated values under FIFO.

Page 31: Moving Average Method Example

Moving Average Calculation

• Shows the calculations under the weighted average method across sales and purchases in a perpetual inventory system.

Page 32: Final Calculation Summary

Summary of Moving Average Inventory Values

• Details of the final calculations for COGS and ending inventory values under the moving average method, wrapping up the concepts discussed in the chapter.